Here Is Something To Think About With Regard to Money

Here is something to think about as the Fed continues to expand its Balance Sheet by buying Treasury (and mortgage debt), with an emphasis on systemic limitations that become a little more apparent at the ZIRP boundary where organic money growth is stultified.

As you may recall, the Fed refunds all profit it makes, that is revenue in excess of expenses, back to the US Treasury. And that includes all the interest collected on the bonds its holds.

So as the Fed buys Treasury debt, and holds it to expiration, it refunds all of the interest payments back to the Treasury, less their expenses.

As long as there is at least one Primary Dealer available to make a market in Treasury debt, the Fed, which is technically prohibited from buying the bonds directly from the Treasury, there is a fairly strong measure of control over both the interest paid and the amount of debt which can be issued.

As a thought experiment, what would it be like if the Fed expressed a willingness to buy ALL outstanding Treasury debt at a set schedule of prices?  What are the limiting factors?  What happens to the debt payments of the Treasury?

Now what would happen if the Bank of England or the European Central Bank stated the same policy for all the relevant sovereign debt?  Would it be the same?  Or why would it be different? 

At the end of the day, the value of a fiat currency is intimately involved in confidence in the mature judgement and trustworthiness of the parties involved in its issuance. 

This is why, although it was superficially 'clever,'  the platinum coin was such a dodgy idea to resolve what was essentially a financing disagreement.

As I have said, at the end of the day, the only limiting factor on the Fed and the Treasury is the value at market of the currency, especially with regard to international transactions.

Isn't fiat currency grand?

Here are two very simple models of currency supply 'management.' The 'considerations' could be thought of as degrees of freedom.

I could have added a significant amount of detail to both pictures, but I wanted to capture the 'essence' of the system in each.  

In the Tripartite Market System the level of debt issuance and its price takes the agreement of at least three parties:  the Treasury, the Fed, and the Debt Market as represented by the Primary Dealer.  In this system it is the level of debt issuance that is managed, and the prices paid for it.

In the Unilateral System the Treasury determines the level of dollar issuance according to its needs.

I *think* one can contrive a non-debt based system that involves more than one party, and does not necessarily require a non-governmental party to be directly involved.

Technically the existing arrangement between the Congress and the President is a two party system.  The Congress authorizes expenditures and the President ratifies, enacts, and adminsters them. 

The 'debt ceiling' arrangement in which Congress refuses to 'pay' by deferring to finance its own previously authorized expenditures is a bit of an anomaly and a symptom of dysfunction.

Shock B: I'll Bust a Cap in Your Curve, And Then Some...

Ben Bernanke and his gangsta bankas have been following the approach outlined in this paper from 2004, Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment, which is excerpted below, and also in his famous 'printing press' speech on avoiding deflation from 2002.

I have written about this before several times over the years, but perhaps it is a good time to review the Fed's game plan.

The first item, communications to model and influence the perception of the markets, is obvious. Jawboning is a major element of any financial intervention. Acknowledging or denying the intervention is all about the message as well.

The most recent statement from the Fed, for example, about keeping rates at the zero bound for the next two years, depending on how the economy fares, is a good example of this. Other actions they may take through their own speeches, and the statements of informal intermediaries in the industry and the press, are good examples as well.

The expansion of the Fed's Balance Sheet is also known as quantitative easing, and that has been done at least twice now, and in epic proportions.

The third option, the targeted purchasing of certain assets, has been done to a large extent to support the banking and mortgage system, but not necessarily the real economy.  This is the program by which the Fed has been taking non-traditional assets into its portfolio in the various vehicles it has constructed in order to shore up the shaky creditworthiness of the TBTF asset profiles.

What the Fed is not doing in a major program yet, although it certainly has done it in the past, is to conspiculously shift the duration of its Treasury bonds portfolio in order to achieve certain interest rate objectives, effectively setting caps on target rates up the curve.

In 1961 in a program called Operation Twist, the Fed moved the duration of its portfolio to help lower longer term rates.  It should be noted that OT1, if you will,  was conducted during the fixed exchange rate period known as Bretton Woods I, which included the redeemability of dollars for gold.  Also, although the short end of the Treasury curve was not at the zero bound,  it was not viewed as adjustable for policy constraints than the zero bound.

So there are some subtle differences perhaps in any OT2 which the Fed might announce this week, or soon thereafter.

John F. Kennedy was elected president in November 1960 and inaugurated on January 20, 1961. The U.S. economy had been in recession for several months, so the incoming Administration and the Federal Reserve wanted to lower interest rates to stimulate the weak economy. Under the Bretton Woods fixed exchange rate system then in effect, this interest rate differential led cross-currency arbitrageurs to convert U.S. dollars to gold and invest the proceeds in higher-yielding European assets. The result was an outflow of gold from the United States to Europe amounting to several billion dollars per year, a very large quantity that was a source of extreme concern to the Administration and the Federal Reserve.

The buying of the longer end of the curve, moving out from the bills to the shorter notes, has been telegraphed repeatedly to the markets this year. So it does appear likely.

The effects would be to lower real rates more broadly across the curve, perhaps taking them all negative, or at least closer to zero on the longer end depending on how one wishes to calculate inflation. I think the Fed uses their chain deflator.  I doubt its accuracy for practical purposes, but let's not quibble.

This is 'bad' for the dollar and good for gold and longer dated Treasuries which will enjoy a brief rally. However it will drive yield hungry investors to seek other alternatives, perhaps in the stock market and overseas.   It may shake up the Treasury markets on the longer end moreso than we might expect if there is an erosion in confidence in the US' ability to put its house in order without devaluation of the dollar debt.  That erosion may be well-founded.

Such a policy move is intended to stimulate consumption and investment in situations where the middle of the curve and out is used as a benchmark for setting non-governmental interest rates.  There is thinking that by moving out from the short maturies, the pull lower on the even longer rates will be more pronounced.

I do not think this alone will work. Banks are reluctant to lend at any price, and lowering the rates would not improve the credit risk profile of potential borrowers.

The Fed could also reduce the interest it pays on reserves to zero, or even place a negative rate on it. This would stimulate banks to put the money to work in the markets for projects with positive yields. This is not so different from the Fed's actions in driving consumers out of short term bonds and zero interest savings accounts, which they have done from time to time.

There is some further indications that the Fed will be using a reverse repo mechanism in order to grow bank credit in a more targeted fashion.  I will not get into that further here, because if it does develop I am sure there will be much more lucid explanations given in some detail based on Fed announcements.

But it does follow the theme of actively stimulating lending in ways other than lowering rates, even on the longer ends of the curve.

The Fed might couple this with government guarantees on loans for example, for certain situations where the government wishes to stimulate activity, such as housing for example. It is hard to imagine anything like this passes through the dysfunctional Congress.

There is another option that the Fed has, which is not cited in the summary of this paper shown below.

For this we have to turn to Chairman Bernanke's famous speech on Deflation in 2002 in which he stated that 'the Fed's owns a printing press' and highlighted various steps which they might take to insure that deflation does not happen in the US, the ability and the resolve of the Fed to prevent it, and some of the options the Fed might have if they reach the infamous zero bound:

However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero. In the remainder of my talk, I will first discuss measures for preventing deflation--the preferable option if feasible. I will then turn to policy measures that the Fed and other government authorities can take if prevention efforts fail and deflation appears to be gaining a foothold in the economy...

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities.

There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates.

A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.

Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association). Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities...

If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities. Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly. However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. (Obviously the Fed has already been doing this as well).

Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934.17 The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.

Each of the policy options I have discussed so far involves the Fed's acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money. (I think the Obama Administration used this as the rationale for extending the Bush tax cuts).

Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets. (I believe the Fed has already been doing this with the help of a few Primary Dealers.)

In summation, I think Bernanke's next move will be to start capping the two and three year rates, with the five year to follow. The purpose will be to keep rates low for the purpose of enabling spending and devaluing the dollar. I do not think he will have to expand the Fed's Balance Sheet to accomplish this.

But it is important to note that while the Congress can enforce a debt ceiling on the US Treasury, there is no such hard ceiling on the Fed's Balance Sheet. And this is probably the genesis of Presidential candidate Perry's scarcely veiled threat to Mr. Bernanke and the use of the word 'treason.'

I am not saying that the Fed is right in what they are doing. I am using Bernanke's thinking, and his own words, to determine what the Fed is likely to do next. I have been using this model for the past five years, and it has served me well. 

I have some sympathy for Bernanke, because he has few allies, especially among the libertine left and the luddites of the right, and the serpentine Obama.  The major obstacle to the US recovery is a failure in governance.

I have very little sympathy for the manipulation of certain markets traditionally viewed as safe havens, based on the rationale outlined in Larry Summer's paper about Gibson's Paradox, and the linkage between interest rates and gold.  That appears to be roughly analagous to machine-gunning the lifeboats.
Deflation or inflation are truly policy decisions in an unconstrained fiat currency regime such as that enjoyed by the US. On this Mr. Bernanke is correct, and anyone who thinks otherwise does not understand a fiat money system.  It really is that simple.  To their credit, the Modern Monetary Theorists understand it very well, except for the downside of excessive money creation in a co-dependent world, even if one does enjoy the exorbitant privilege of the world's reserve currency.

Various interests have been seeking to restrain the Fed, ranging from large creditors such as China, and the domestic monied interests who have already received their bonuses and bailouts, and who do not wish to see their dollar wealth erode. One is richer if all around them are made relatively poorer, or so some lines of thinking go.  And of course there are the prudent savers, who have been fleeing the dollar to the relative safety of some foreign currencies and hard assets like gold and silver.

I would hope that by now that any reader here would know that, at least in my judgement, deflation through hard money and austerity, or inflation through stimulus and money printing, are both unable to achieve a sustainable economic recovery because the system is caught in a credibility trap in which the governance of the country is unable to act justly and reform the system without implicating themselves in the compliant corruption that caused the unbridled credit expansion, massive frauds, and financial collapse in the first place. 

This was a major contributor to Japan's lost years.  The lack of will was in the failure of their largely single party system to correct the inefficiencies and crony capitalism of the banks and their keiretsus that provided a drag on all stimulus and the real economy, siphoning off the additional money into unproductive projects and support for zombie corporations.

The Banks must be restrained, and the financial system reformed, with balance restored to the economy, before there can be any sustained recovery.

Federal Reserve
Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment

Ben S. Bernanke, Vincent R. Reinhart, Brian P. Sack

8 April 2004


Abstract

 The success over the years in reducing inflation and, consequently, the average level of nominal interest rates has increased the likelihood that the nominal policy interest rate may become constrained by the zero lower bound.

When that happens, a central bank can no longer stimulate aggregate demand by further interest-rate reductions and must rely on “non-standard” policy alternatives. To assess the potential effectiveness of such policies, we analyze the behavior of selected asset prices over short periods surrounding central bank statements or other types of financial or economic news and estimate “no-arbitrage” models of the term structure for the United States and Japan.

There is some evidence that central bank communications can help to shape public expectations of future policy actions and that asset purchases in large volume by a central bank would be able to affect the price or yield of the targeted asset.


Non-Technical Summary

 Central banks usually implement monetary policy by setting the short-term nominal interest rate, such as the federal funds rate in the United States. However, the success over the years in reducing inflation and, consequently, the average level of nominal interest rates has increased the likelihood that the nominal policy interest rate may become constrained by the zero lower bound on interest rates. When that happens, a central bank can no longer stimulate aggregate demand by further interest-rate reductions and must rely instead on “non-standard” policy alternatives.

An extensive literature has discussed monetary policy alternatives at the zero bound, but for the most part from a theoretical or historical perspective. Few studies have presented empirical evidence on the potential effectiveness of non-standard monetary policies in modern economies. Such evidence obviously would help central banks plan for the contingency of the policy rate at zero and also bear directly on the choice of the appropriate inflation objective in normal times: The greater the confidence of central bankers that tools exist to help the economy escape the zero bound, the less need there is to maintain an inflation “buffer,” bolstering the argument for a lower inflation objective.

In this paper, we apply the tools of modern empirical finance to the recent experiences of the United States and Japan to provide evidence on the potential effectiveness of various nonstandard policies. Following Bernanke and Reinhart (2004), we group these policy alternatives into three classes:

1. using communications policies to shape public expectations about the future course of interest rates;
2. increasing the size of the central bank’s balance sheet, or “quantitative easing”; and
3. changing the composition of the central bank’s balance sheet through, for example, the targeted purchases of long-term bonds as a means of reducing the long-term interest rate.

We describe how these policies might work and discuss relevant existing evidence...

Additional Reading:
The Upcoming Expansion of US Bank Credit - Alasdair MacLeod

Gold and Interest Rates: More than Joined at the Hip - Rob Kirby

“The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it.”

John Kenneth Galbraith

What Next from the Fed: the Obvious, More of the Same, Secrecy, and Inevitably Devaluation

I suspect that this is a 'trial balloon' story that the Fed sends out as a means of informing its constituents about the likely paths of it policy, to solicit feedback and prepare the way.

What is most disappointing is that they are considering the obvious, and more of the same.

The cutting of the interest paid on reserves to zero is something which I have been predicting for some time, despite serious wonkish scoffing from some economic circles that I will not shame to mention. No, it is not a useless or meaningless thing to do.

That will be a real move to ZIRP. But it also removes a welfare payment to a few of the Too Big To Fail Banks which are still remarkably insolvent and running on unsustainable business models, so the Fed will proceed slowly. That is the real 'technical issue.' The Fed never paid such interest before, so to say now that it is a systemic requirement is a bit disingenuous. It is a requirement if your system is broken, and not in the process of being fixed.

As for tweaking their wording, OMG. Benny is losing confidence fast. In the last few statements the Fed was largely talking to themselves. In the second part they make a great deal of playing to foreign creditors. That makes more sense, but we are clearly in that endgame. China does not buy Treasuries because they enjoy the returns on their bonds. They buy them because it is part of the policy of currency manipulation to subsidize their domestic economy. When they decide to stop they will stop. And that goes for the oil states as well, with slightly different motives.

More monetization, the buying of existing debt, gets down to the heart of the program, their game plan, but note please that this is just a way to subsidize the creditors, keeping people in houses that they cannot afford almost at any interest rate. The principal still reflects bubble pricing, and must be reduced. The associated debts will have to be written off, not refinanced.

The Fed is still acting primarily in the interest of the Wall Street banks, and Timmy and Larry are they yes-men in the government.

Based on what I am seeing, when push comes to shove, Benny is going to print, and devalue the dollar, because he sees no other options, lacking the will and imagination to create other choices in addition to merely debasing the currency and stealing the rest of the savings of a generation.

The monied elite do not favor this, and will attempt to promote ridiculous austerity programs, to direct the pain more heavily towards the middle and lower class.

And so the class and currency wars begins to gain momentum.

Washington Post
Federal Reserve weighs steps to offset slowdown in economic recovery
By Neil Irwin
Thursday, July 8, 2010

Federal Reserve officials, increasingly concerned over signs the economic recovery is faltering, are considering new steps to bolster growth.

With Congress tied in political knots over whether to take further action to boost the economy, Fed leaders are weighing modest steps that could offer more support for economic activity at a time when their target for short-term interest rates is already near zero. They are still resistant to calls to pull out their big guns -- massive infusions of cash, such as those undertaken during the depths of the financial crisis -- but would reconsider if conditions worsen.

Top Fed officials still say that the economic recovery is likely to continue into next year and that the policy moves being discussed are not imminent. (They know this is not true, but it does not hurt to try and talk up the good news while waiting for a break, even if it is the outbreak of war - Jesse)

But weak economic reports, the debt crisis in Europe and faltering financial markets have led them to conclude that the risks of the recovery losing steam have increased. After months of focusing on how to exit from extreme efforts to support the economy, they are looking at tools that might strengthen growth.

"If the economic situation changes, policy should react," James Bullard, president of the Federal Reserve Bank of St. Louis, said in an interview Wednesday. "You shouldn't sit on your hands. . . . I think there's plenty more we could do if we had to."

One pro-growth strategy would be to strengthen language in Fed policy statements that the central bank's interest rate target is likely to remain "exceptionally low" for an "extended period." The policymakers could change that wording to effectively commit to keeping rates near zero for even longer than investors now expect, perhaps adding specifics about which economic conditions would lead them to raise rates. Such a move would be opposed by many members of the Fed policymaking committee who are wary of the "extended period" language, arguing that it limits their flexibility. (zzzzzzz - Jesse)

Another possibility would be to cut the interest rate paid to banks for extra money they keep on reserve at the Fed from 0.25 percent to zero. That would give banks slightly more incentive to lend money to customers rather than park it at the Fed, although it also could cause technical problems in the functioning of certain credit markets. (As I have predicted. The Fed NEVER paid interest on reserves before now. How can it suddenly cause serious problems if they stop it? If they had the nerve, they could take those interest rates mildly negative. That would give the banks some incentive to get the funds moving, although it would be disruptive and would have to be done slowly, with plenty of warning - Jesse)

A third modest possibility would be to buy enough new mortgage securities to replace those on the Fed balance sheet that are paid off as people take advantage of low interest rates to refinance. (More monetization to support the creditors and Wall Street. Oh yeah that will work. - Jesse)

Role of mortgage rates

None of those steps amounts to the kind of massive unconventional effort to drive down mortgage rates and prop up growth that the Fed took in late 2008 and early 2009, when the economy was in a deep dive. Then, the Fed began buying Treasury bonds, mortgage securities and other long-term assets -- more than $1.7 trillion worth by the time the purchases concluded in March. (The Fed and Treasury have done very little to restructure the financial system and the US economy to make it sustainable, and that is their failure. They think Wall Street is the sine qua non - Jesse)

Some economists have encouraged the Fed to launch a new asset-purchase program, saying that with the unemployment rate at 9.5 percent (really north of 17 % - Jesse) and little apparent risk of inflation, (this is not true and it why the Fed is so cautious - Jesse) the Fed should use every tool at its disposal to get the economy back on track.

Fed leaders view such a strategy as likely to have only a small impact on the economy and as carrying a risk of slowing growth.

One of the key ways the earlier securities purchases stimulated the economy was by driving down mortgage rates, which in turn propped up the housing market. But with mortgage rates near all-time lows, it is not clear that actions to lower rates another, say, quarter percentage point would result in much additional home sales or refinancing activity. (It would save some foreclosures perhaps, but the problem is that the wealth transfer from the many to the few is running overtime now that the banking frauds collapsed and they have to scrambled for earnings with great vigor on old scams like price manipulation in the markets - Jesse)

Moreover, the Fed's purchases of mortgage securities have reduced the role of private buyers in that market, and some leaders at the central bank fear that further intervention could delay the resumption of normal market functioning. (ROFLMAO - when it makes sense they will buy regardless of what Benny is doing. They just want subsidies now and high yielding hot money schemes. They are not interested in low paying high risk investments - Jesse)

"The Fed probably believes that unconventional policy does not have much traction as market functioning gets better," said Vincent Reinhart, a resident fellow at the American Enterprise Institute and a former Fed official.

Asset-purchase plan

Another risk is that global investors could lose faith that the Fed will be able or willing to pull money out of the economy in time to prevent inflation. That would lead the investors to demand higher interest rates on long-term loans, which could reverse the rate-lowering effects of the Fed's asset purchases. (This is the inflation risk which I said exists, which they said above does not exist - Jesse)

When the Fed was buying $300 billion in Treasurys in mid-2009, part of its try-everything approach to dealing with the crisis, rates on 10-year bonds temporarily spiked amid concerns that the Fed was "monetizing the debt," or printing money to fund budget deficits. With deficit concerns having deepened in the past year, such fears could be even more pronounced now.

All that said, Fed officials do not rule out launching a major new asset-purchase program. Rather, they say they would consider one only if their basic forecast -- of continued steady expansion in the economy -- proves to be wrong. A key factor that would build support for new asset purchases would be a rise in the risk of deflation, or a dangerous cycle of falling prices -- which has become more of a concern as the world economy slows. (Deflation is a policy choice, always, in a purely fiat currency regime - Jesse)

Fed officials express confidence that they have tools to address the economy further if conditions worsen.

"I think we do have a variety of tools available, and we shouldn't rule any tool out," Eric Rosengren, president of the Federal Reserve Bank of Boston, said in an interview. "If we're uncomfortable with how long it's going to take us to reach either element of our dual mandate [of maximum employment and stable prices], we'll have to make some adjustments to policy."

Where We Are Today: Interest Rates 'Too High,' Double Dip on Deck, the Failure of Economics

David Rosenberg of Gluskin Sheff is a daily read of mine. His most recent breakfast message does a remarkably concise job of summarizing the US financial markets.

The reason for the gold market rally is obvious; declining production in the face of record monetization and increasing demand. The same financial engineers in the central banks that ruined the economy had been suppressing the price of gold through managed sales for almost thirty years in a desperate reaction to the Nixon assault on Bretton Woods in 1971. And now we see the fruits of their long contrivance, and its inevitable failure. The world will have to develop a replacement to this incredible farce we call globalization and world trade based on arbitrary and easily manipulated values.

At the same time, Dave points out that according to the Taylor Rule the Fed is overly tight, even with ZIRP! We have spoken about this in the past, in making a distinction between quantitative and qualitative easing. This also speaks to the massive deformity which the US economy had become under first Greenspan and then Bernanke, and a financial sector turned outsized predator, with little connection to real market discipline of supply and demand thanks in large part to the proliferation of derivatives.

Ben could mitigate this with the interest payments on reserves which the Fed is now allowing. I suspect at some point he will, even taking them negative if necessary. But the Fed's first priority is the insolvent Wall Street firms, and the continued charade that allows them to still pay outrageous bonuses while the nations suffers between the hammer of unemployment and the anvil of a toxic disaster in the Gulf and the collapse of its local economies. The first policy failure was in not nationalizing the insolvent US banks like Goldman and liquidating them. The second policy error is the failure to engage in serious financial reform, severely curtailing the derivatives market to something more resembling a well regulated insurance industry, and separating it completely from the commercial banking system.

It takes a certain kind of mindset and attitude to understand this dynamic, and few economists have yet taken up that challenge; economic contraction in the face of very low interest rates, with gold soaring in a bull market while long term inflation vectors are near record lows. It should be acknowledged that the Fed is active in the markets, 'tinkering' with the longer end of the yield curve among other things. And of course, derivatives, easily printed and without position limits, are pressed on various targets in the real economy almost at will by the banks and hedge funds, distorting prices and markets, destroying real wealth.

And yet this is what we have, facts in collision with theories. The austerity reaction in Europe is the resurrection of Hoover, of the liquidationism which drove the US into the agony of the trough of the Great Depression of 1933. This was of course the moment of failure for the Austrian School. It is one thing to be able to spot a problem and to stop it ahead of time, which their theories do well. But the Austrians seemed unable then, and now, to recommend practical and implementable programs to remedy the current situation in which the US now finds itself.

This is not to say the theory has failed, but rather that it has intellectual arteriosclerosis and atrophy. It is one thing to read and write about riding a bicycle or having sex; it is another thing to get out of your rooms and do it, and actually learn something. To their credit they were certainly not fooled by the neo-liberals. But their response is little better than the neo-Keynesians, which is to reflexively stimulate or liquidate without practical reforms and actually fixing the distortions which policy errors over a long period of time have caused.

I have to admit that I like to tweak the nose of 'the Austrian school' now and then. But since I tend to hit the neo-liberals with brass knuckles, and the neo-Keynesians with the kind of premeditated distance one gives to a crotchety old maiden aunt dwindling into senility, I would hope they understand that it is not personal; all of the modern schools of economic thought have failed. All of them, for varying reasons. That is all well and good and human, but it is the lack of recognition of that failure, and the resolution to adapt and do better, and to roll up one's sleeves and actually shame the politicians into doing better for the people, that is so cloying.

The failure of economists in general to speak out, except in the usual sniping reminiscent of departmental politics, is leaving the field open to quackery, and the draconian measures of oligarchy. Just as their failure to speak out permitted China to distort the world economy, and Greenspan to destroy the economic infrastructure of the US.

The current economic landscape seems littered with self serving cronyism, broken theories disconnected from reality, quackery, and obtuse boasting from dismal failures. Economics seems more like astrology, or Elliot Wave theory, or the writings of Nostradamus, with so little rigor that it can be used to 'prove' or justify just about any outcome, after it has happened. In short, economics seems these days to be little more than propaganda, social commentary rather than harder science or something as simply practical as mechanical engineering.

What I am saying is that all the economic schools of thought have come up short, failing badly, the free market neo-liberals most spectacularly of all. Their failure is not in having got it wrong, but in continuing to beat the dead horses of their theories until the stench is unbearable.

The lack of significant financial reform, and restraint of unbridled speculation through the use of derivatives, is going to strangle the western world until they can bring themselves to restrain their banking system gone mad.

The U.S. turned 234 years old yesterday, and yet over half of the nation’s money supply was created since Helicopter Ben took over the flight controls four years ago.

No wonder gold is in a full fledged bull market. The annual output of gold has declined 12% in the past decade while the marginal cost has more than doubled, to $500, according to David Hale. Moreover, David points out in his recent report that since 1900, more than 80% of the world’s proven reserves have ready been mined.

The marginal cost of pressing on Dr. Bernanke’s printing machine is basically zero, and, the prospects of a re-expansion of QE by the Fed as double-dip risks rise with each and every passing data-point are rather high.

Gold has corrected to the 50-day moving average in recent weeks, which in the past has been a terrific entry point — for the past six months, each low has been higher and each high has been higher too. Nice upward channel that is to be respected and to be bought.

As for double dip risks, the ECRI leading index is predicting over 50-50 odds of such, and is exactly where it was in December 2007 when unbeknownst to the vast majority at the time that the downturn was just getting started.

As an aside, even after cutting his growth forecast on Friday, Bank of America’s chief economist went on CNBC after the market closed and declared that the economy would manage to “muddle through” — this has now become the widespread consensus that all this is nothing more than a temporary soft patch. [akin to quicksand, an economic netherworld such as that which the kereitsu inflicted on the people of Japan - Jesse]

Jeffrey Frankel, a member of the NBER’s business cycle committee, had this to say over the weekend:

“You cannot rule out a double dip, in light of Europe’s problems … I think the next couple of months of indicators will be more telling than the last couple of months.”

Economists have spent so much time trying to assess when the last recession ended that they have taken the eye off the ball as to when the next one would begin. Yet this is what the NBER is grappling with — maybe the same day the NBER announces that the last recession ended in June 2009, they will tell us that another one began in June 2010.

Can a sub 3% yield on the 10-year note and the “flattest” Treasury curve (still near 230bps, mind you, for the 2s/10s spread) in nine months really be sending out the wrong message of heightened hard-landing risks? Or, for that matter, the lowest close in the S&P 500 since September 4th of last year. Did anyone back then think we would go from Labour Day to Independence Day with nothing to show for it?"

...What does not get enough play is that Fed policy is tighter than it should be right now, based on the Taylor Rule, believe it or not — zero policy rate and the size of the Fed’s balance sheet is equivalent to a -2% rate, when at this stage the two tools should be equivalent to a -5% rate. [We might have an effective negative rate if the government had not fouled the measures of inflation - Jesse] And, fiscal policy is actually far less stimulative than meets the eye when the impact of State/local government restraint is factored into the equation. In the past two months, whether one looks at the Kansas City or St. Louis Fed’s stress indices, there have been 60 basis points of tightening in overall financial conditions, just as the economy is hitting a possible inflection point.

David Rosenberg, Gluskin Sheff, Breakfast with Dave

A double dip recession will be a strong indication, if not a proof, of policy error, both on the part of the Federal Reserve and of the Obama Economic Team. When the recession can no longer be hidden from the public the reaction could be swift. The oligarchs are acting pre-emptively to cushion the blow on their ill gotten gains by preaching austerity measures, at a time when the lower and middle classes are taking it on the chin. Empathy and common sense have little place with obsessive sociopaths

Part of the problem is the China peg to the US dollar. This obviously thwarts the international market's system of checks and balances, its ability to adjust naturally to changes in economic fortunes. That peg and devaluation ought never have been allowed.

But this is merely one instance in a series of economic manipulations and sometimes aggressive deceptions by the world powers that have been occurring since 1971, when Nixon unilaterally broke the Bretton Woods regime and took down the international gold standard, and not incidentally brought Greenspan into the service of the federal government.

Reform is the only solution that is sustainable. Austerity or stimulus without reform are worse than useless. One does not fix a car with a blown engine by flooding it with gasoline, since it did not run out of gas, but in fact blew up from prolonged abuses and disrepair. And on the other hand, one cannot restart the economy by watching it burn, waiting for the flames to extinguish themselves, hoping for a chance to start over anew and do it 'the right way' according to theory. By the time you would wish to get started, there will have been a revolution conducted by the impatient and long suffering people. So what does one do?

You fix it. You restore it to a state when it was last actually working, and resist the temptation to 'optimize' and redesign it on the fly, cramming in pet projects that surpass performance tweaks. That can come later, after the system is running again in some reasonable way. You take the harder hits when they can be absorbed with toppling the recovery.

That is how it is. Everything else is noise, excuses, partisanship, and waffling.

T-Bills Hit Zero

AP
Point of no return: Interest on T-bills hits zero
By MADLEN READ and MARTIN CRUTSINGER
December 9, 2008

NEW YORK – Investors are so nervous they're willing to accept the same return from government debt that they'd get from burying money in a coffee can — zero.

The Treasury Department said Tuesday it had sold $30 billion in four-week bills at an interest rate of zero percent, the first time that's happened since the government began issuing the notes in 2001.

And when investors traded their T-bills with each other, the yield sometimes went negative. That's how extreme the market anxiety is: Some are willing to give up a little of their money just to park it in a relatively safe place.

"No one wants to run the risk of any accidents," said Lou Crandall, chief economist at Wrightson ICAP, a research company that specializes in government finance.

At last week's government auction of the four-week bills, the interest rate was a slightly higher but still paltry 0.04 percent. Three-month T-bills auctioned by the government on Monday paid poorly, too — 0.005 percent.

While everyday people can keep their cash in an interest-earning CD or savings account at the bank, institutional investors with hundreds of millions of dollars on their hands often use government debt as part of their investment strategy.

In the Treasury market, the U.S. government, considered the most creditworthy of borrowers, issues IOUs of varying durations to raise money.

The zero percent interest rate is no reason to panic. As recently as Monday, investors were plowing cash into stocks, and averages like the Dow industrials are off their lows.

And long-term government bonds, while near record lows, are still paying decent money considering the tumultuous climate. The yield on a 30-year bond on Tuesday was a little higher than 3 percent.

There's good news in all this for taxpayers: Low interest rates on government debt mean the United States is financing its $700 billion bailout of the financial system very cheaply. The Treasury has sold mountains of debt to pay for it.

But the trend also underlines stubborn anxiety in the financial market that could keep the economy sluggish for years to come, and it translates into stagnant returns for people who have their money in places like money market funds.

"There's a price for safety," said Peter Crane, president of money market mutual fund information company Crane Data LLC. "Down slightly is the new up."

As the stock market has taken its alarming plunge, people have been moving money from riskier assets to safer ones. According to Crane Data, funds invested purely in Treasurys have surged more than 150 percent over the past year, to $726 billion.

Earning zero percent on an investment for a short while may not seem that dire for the average person. But a zero percent rate has serious consequences for the complex credit markets.

Those markets have been dysfunctional since Lehman Brothers Holdings Inc. went bankrupt in September, scaring away investors who normally buy bonds from seemingly creditworthy borrowers. Lending, the lifeblood of the economy, has frozen up.

One corner of the credit markets is the repurchase markets, known as "repo," where banks and securities firms make and receive short-term loans backed by collateral, usually Treasury bills.

When those T-bills are yielding nothing, there's little incentive to deliver them on time. If the holder loses the interest, it's no big deal.

"This is a particular problem in a time like this, because people are buying Treasury securities for their security, for their safety. It's important that they're delivered," Crandall said. (You can bet the shorts are piling on - Jesse)

And high demand for government debt rather than corporate debt could stifle economic growth.

Corporate bond rates have been surging to record levels compared with Treasurys, which makes it more expensive for companies to raise money. And when companies can't raise money, they often have to cut costs, sometimes through layoffs.

Only a few corporate bond deals have been going through lately, and most have been through the government, which has agreed to guarantee financial institutions' bond sales. American Express Co., for one, said Tuesday it has issued $5.5 billion through the government program.

Many worry that the government will become the most attractive lender and borrower in the market — crowding out others in the private sector....

Breaking the ZIRP barrier

From Across the Curve:

T Bills
December 4th, 2008 11:42 am

I just spoke to a bill trader who noted that a large chunk of the bill list is trading at zero percent. He mentioned a point that I had forgotten but is worth noting. Bills always trade well in December because at year end there is demand for them as investors of every ilk dress up their balance sheets. He has seen that demand to a far greater extent than normal.

He says that given all that has transpired this year there will be enormous demand for bill through the entire month of December. He has seen demand from an eclectic group of investors from around the globe. He expects the treasury to announce shortly a series of cash management bills which would total about $100 billion.

In his opinion if they do not issue bills will scream through zero.

So get used to these low rates they are here for a while.

Let's revisit the current situation.



The comparisons are not quite focused with today in terms of bills and bonds, since the funding preferences of Treasury are different now than they were back then, but you get the general idea of 'Treasuries' and their role in a flight to safety in a portfolio allocation.

The New Deal for the Banking System as the Financial Storm Intensifies

"Do you think he is so unskilful in his craft, as to ask you openly and plainly to join him in his warfare against the Truth? No; he offers you bait to tempt you. He promises you civil liberty; he promises you equality; he promises you trade and wealth; he promises you a reduction of taxes; he promises you reform... He prompts you what to say, and then listens to you, and praises you, and encourages you. He bids you mount aloft. He shows you how to become as gods. Then he laughs and jokes with you, and is familiar with you; he takes your hand, and gets his fingers between yours, and grasps them, and then you are his."
J.H. Newman, The Times of AntiChrist, 1889

We are seeing an enormous parody of Roosevelt's New Deal being rolled out in a hurried fashion for the bankers and the wealthy under the cloak of dire necessity prior to the likely change in political Administrations.

If we follow the political pattern of the 1930s, we will see a minority of Republicans and a sympathetic majority at the Supreme Court attempt to maintain the disbursal of liquidity largely to the corporations and banks, and to fight any progressive tax increases and social programs designed to push that liquidity directly to the public without passing through the tollgates of the financial system.

If this happens, we may see a powerful polarization in the country between a minority that will attempt to embrace state control to halt those programs and the encroachment on 'true American principles' and a suffering public, with a middle class pinned between them.

The corporatist appeal will be made to social conservatives, small businessmen, the banks and the corporations that spring up around them, and the lowest elements in the hatreds and prejudices and fears in the public, particularly the older middle class, to retrieve our national honor.

And if against all safeguards and probability this succeeds in gaining power, and burning the Constitution to preserve our freedom becomes a popular slogan, and a slyly articulate but otherwise inexperienced, almost mediocre, leader arises, and the corporate powers support this person in order to achieve their ends, then it will be time to leave, without looking back, before the storm breaks, and madness is unleashed, and a darkness falls over the land.

Bernanke May Seek New Ways to Ease Credit as Fed Rate Nears 1%
By Craig Torres

Oct. 23 (Bloomberg) -- Federal Reserve officials are likely to bring interest rates down so aggressively over the next few months that they will have to search for fresh tactics to continue easing credit.

The Fed's Open Market Committee will probably reduce the benchmark federal funds rate by half a point next week to 1 percent, the lowest since May 2004, according to futures trading. The official rate has never been lower since the Fed made it an explicit target in the late 1980s.

Further cuts below 1 percent could turn Fed Chairman Ben S. Bernanke's focus away from the main rate and toward more use of alternative tools. Those might include increasing its holdings of mortgage bonds to lower costs for homebuyers and purchasing securities directly from the Treasury in order to pump more cash into the economy, Fed watchers said.

``If there is need for more stimulus, the Fed will buy up government debt to keep borrowing costs low," said Adam Posen, deputy director at the Peterson Institute for International Economics and a co-author with Bernanke. That's tantamount to ``turning government debt, as it is issued, into money.'' (That is pure monetization and they can do it if they have the will and the need - Jesse)

Bernanke, 54, has already thrown the central bank's balance sheet into action in unprecedented ways. Working with the New York Fed, the Board of Governors has rolled out 11 new programs aimed at absorbing risk or making dollars available when banks don't want to loan. (A New Deal for the Banking System - Jesse)

Assets Doubled

The result: The central bank's assets, which include a loan to insurer American International Group Inc. and a pool of investments once held by Bear Stearns Cos., more than doubled to $1.772 trillion last week from a year-earlier total of $873 billion that comprised mostly Treasuries. The latest weekly figures are scheduled for release at 4:30 p.m. in Washington.

There's more to come. The Fed announced this week a backstop for money-market mutual funds to which it will commit another $540 billion. A commercial-paper program approved Oct. 7 could buy up to $1.8 trillion of securities.

``The net effect of these facilities has been a truly staggering pace of growth in the Fed's balance sheet,'' said Jan Hatzius, chief U.S. economist for Goldman Sachs Group Inc.

When the Bank of Japan fought deflation and a banking collapse earlier this decade, its balance sheet ballooned to more than 30 percent of gross domestic product as it pumped money into the economy, Hatzius said. He predicted ``further rapid growth'' in the Fed's, which is now equal to 12 percent of U.S. GDP. (The policy error is that they pumped the money into foolish projects and into an unreformed financial system, hopelessly compromised by the keiretsu corporatism of interlocking insider dealing. One does not start an engine that is broken by pouring more fuel into it. - Jesse)

`Helicopter Ben'

As a Fed governor, Bernanke did research on alternative policy tools between 2002 and 2004, when U.S. central bankers last cut the benchmark rate to 1 percent. Traders nicknamed him ``Helicopter Ben'' after a 2002 speech that referenced Milton Friedman's comments comparing such unorthodox methods to dropping money from a helicopter.

Vincent Reinhart, the Fed's director of monetary affairs at that time, said Bernanke's policy activism, which contrasts with his predecessor Alan Greenspan's almost exclusive use of the federal funds rate, derives from the chairman's research on policy errors in the Great Depression and during Japan's rolling recessions of the 1990s.

``He saw what we viewed as an obvious policy failure and it was in the ability of human reason'' to fix it, said Reinhart, now a scholar at the American Enterprise Institute.

`Quantitative Easing'

The Bank of Japan, struggling against deflation, slow growth and consumers' reluctance to spend, brought its policy rate close to zero before turning in 2001 to a so-called quantitative easing strategy of increasing money in accounts held for commercial banks. The policy lasted for five years, before the central bank began to draw down reserves and raised its benchmark rate to 0.5 percent, where it has been since February 2007.

The Fed has flooded the economy with so much cash that excess reserve balances at banks, or cash surpluses beyond what banks are required to hold against deposits, soared to $136 billion for the two-week period ending Oct. 8 compared with an average of $1.4 billion in the same month last year. (We showed this in a chart the other day. They are stuffing the banks with liquidity, and the banks are holding the reserves against writedowns and credit risk. At some point this will spill over and perhaps even break out, into what contrivances who knows. We may see a rise of 'superbanks' through acquisition. These will have to be taken apart in the coming years. - Jesse)

``The Federal Reserve has already entered a regime of quantitative easing,'' said Brian Sack, vice president at Macroeconomic Advisers LLC who also worked with Bernanke as an economist in the Monetary Affairs Division.

As their liquidity programs dump excess funds into the banking system, it's become more difficult for the Fed to keep the rate at which banks lend overnight to each other in line with policy makers' 1.5 percent target. (This is an absolutely key point to keep in mind - Jesse)

Below Fed Target

In an effort to put a floor under the overnight rate, the central bank started paying interest on the reserves banks deposit with it. That hasn't stopped the so-called effective federal funds rate from falling below the target every day since officials lowered their benchmark by half a point in an emergency move on Oct. 8.

In the two weeks since then, evidence of a deteriorating economy has mounted and will likely push Fed officials toward a further rate cut when they meet Oct. 28-29, economists said.

Industrial production in the U.S. fell in September by the most in almost 34 years, and retail sales dropped by the most in three years. Inflation pressures are easing as oil prices fall to a 16-month low, and nine months of job losses eliminates any pressure from wage increases.

Whether the target rate ends up below 1 percent depends on how fast consumers and businesses gain more access to low-cost credit. Economists at HSBC Holdings Inc. said the Fed would like to avoid cutting to zero. Still, if the economy doesn't improve, it ``could be at zero'' by the middle of next year, said HSBC economist Ian Morris.

``There is this understanding at the Fed that the worst thing you can do is save your ammunition,'' said Ethan Harris, economist at Barclays Capital Inc. ``You move fast -- that is the whole lesson of past crises in Japan and during the Great Depression.''