Jesse's Café Américain

Chris Whalen captures an interesting aspect of change that not only the august US Senators are missing, but most of the mainstream media in the States as well, at least judging by the discussions on their Sunday political shows. All of them seem equally out of touch, arrogantly aloof and insulated from the mood of the nation.

It is interesting also to hear the financial princes growling from lofty Davos about 'Obama's outburst' regarding the Volcker Rule and the impertinence of the Americans in daring to set national regulations for their banks.

Is this an historic moment? Are the people challenging the rule of a burgeoning financial elite, which is puzzled at the sudden rebellion against their enlightened rule?

I think that the answer might be yes, and this is what Ron Paul alluded to in his video regarding 'revolutionary changes.'

And one can only marvel at the way in which the Democrats are committing political suicide after being handed the reins of power with an overwhelming majority, out of what appears to be sheer, almost incomprehensible arrogance and fundamental incompetence. Watching the toad Geithner testify is painful beyond expression.

Will the Americans lead the storming of the Banking Bastille? And will the cowed Brits dare to defy their ubiquitous surveillance cameras and raise their voices for change?

Surely a politician's worst nightmare, a crisis gone wrong. This is the point at which the people ought to be laying down their liberty for the security of a return to credit lending, and a banking system that defers from crashing their markets.

I also have to wonder how the politicians forget the lessons of the past, and the downfall of once mighty leaders of popular governments. It is never about the first offence, the original act itself which may seem trivial.

What brings down governments is the cover up, the conflicts of interest, the pettiness of tone deaf arrogance, and the ensuing loss of confidence.

Fed Deception of Congress Regarding AIG

"Even as the Senate prepares to vote on the Bernanke nomination, Rep. Darrell Issa (R-CA) has asked the Chairman of the House Committee on Oversight and Government Reform to subpoena AIG-related documents from the Fed, documents which apparently prove that Chairman Bernanke played a major role in deciding to bail out AIG and, indirectly, Goldman Sachs (GS) and other large bank dealers.

In a January 26, 2010 letter obtained by The IRA, Issa claims that Bernanke overruled a recommendation by Fed staff that AIG be allowed to declare bankruptcy "just like Lehman Brothers" and instead authorized the bailout of the crippled insurance giant over the objections of Fed staff in Washington. The Fed appears to be withholding these documents from Congress until after the Senate votes on the Bernanke nomination.

Rep. Issa, the ranking member of the Committee, refers to a statement by Senator Jim Bunning (R-KY), whose staff has been examining these same documents under strict rules of confidentiality imposed by the Fed's staff, to the effect that Chairman Bernanke overruled the recommendation of his staff and pushed the bailout of AIG. How can the Senate vote on the Bernanke nomination when the Fed is refusing to comde clean on AIG?

Members of the Senate need to ask themselves a question: With the current disclosure by the Fed, what further revelations will surface regarding the central bank, AIG and the bailout of the large New York banks between now and November?

So given the above, why is Chairman Bernanke seemingly en route to confirmation? Why do members of the Senate seem to indifferent to the mounting popular anger at Chairman Bernanke and the Fed? There are several reasons the Senate is making a major political and economic miscalculation in its appraisal of Ben Bernanke's role at the Federal Reserve. The most significant is that Senators think that the Federal Reserve and the bailouts are not voting issues, because there are no traditional organized constituent groups that lobby around them.

Staffers who frame issues for Senators do not know that Fed and its profile in American politics has changed in a way reminiscent of the days of President Jackson and the battle over the Second Bank of the United States. After all, issue groups have an incentive to mislead incumbent Senators in a way biased towards the interest of incumbent financial interests. This is a terrible mistake for the political health of any Senator who wants to get reelected in 2010 or 2012. The bailouts happened from 2008-2009, and voters now understand them and loath them. And this applies equally to Democrats and Republicans in the Senate.

Look at how the Fed and AIG are changing the dynamic for incumbent GOP Senators. Republicans are seeing bailout-themed primary campaigns, where incumbents like Utah Senator Bob Bennett and Arizona Senator John McCain are explicitly attached to the bailouts. As noted above, democrats saw losses in Virginia, New Jersey, and Massachusetts. And Brown voters in Massachusetts showed significant dissatisfaction with Democratic ties to Wall Street. But the same populist wave will carry away Republicans as well.

Bottom line: A "yes" vote for Chairman Bernanke raises the likelihood of defeat for every member of the Senate standing for election in 2010 and 2012. And in any event, the rising tide of popular unhappiness with Washington and Wall Street promises to remake the American political landscape in a way not seen in the post WW II era. The comfortable assumption of stability in American political life is about to be replaced by instability and change, but that is what democracy is all about."

Political Risk: The Bernanke Nomination and the Return of American Populism - Institutional Risk Analyst

"What does the Fed think will change if they can avert a crash again and maintain the status quo at the cost of yet another asset bubble?

Is the Fed trying to maintain an inherently unstable economic order that requires increasingly extraordinary means and ever greater imbalances to keep it from collapsing? I believe that they are.

Will the Fed have to keep assuming more and more power and control over the real economy to sustain the unsustainable until they destroy what they had intended to save? I think the answer is yes."

Quantitative easing effectively means providing the financial system with liquidity well in excess of organic commercial demands and conventional open market operations. The Fed does this by expanding its balance sheet extraordinarily, hence the spectacular growth in 'excess reserves' of commercial banks.

The Fed does this for several reasons. The first obviously is to supply reserve capacity to the banks when their own reserve base has deteriorated badly to the point of insolvency. A second reason is to permit the Fed to expand its Balance Sheet in an extraordinary manner, in order to absorb assets that cannot be marked to market by a commercial bank without significantly damaging their own balance sheet. A third reason of course is to take an accommodative stance with regard to real interest rates when nominal rates approach zero.

One of the issues that quantitative easing creates is that it is problematic to continue to effect a fed funds rate. The usual method is to set a target, and then make changes in the levels of liquidity in the system through adds and drains of financial assets like Treasuries to achieve it. This is why Fed Funds is called a 'target rate.'

But how can one do this when the tool of policy making has been thrown in a ditch by the adoption of quantitative easing, by definition driving rates to zero? It is all "adds" and no drains, stuffing the goose beyond its capacity as it were.

Make no mistake: quantitative easing is to central banking what the introduction of nitroglycerin was to conventional warfare. It kicks the power of financial engineering up a notch, to say the least, and brings in an element of risk of more than normal inflationary pressures.

The Fed can set a 'floor' under the overnight interest rate without engaging in open market operations by offering to take reserves and pay a set rate as interest. Presumably banks will take a riskless .25% rather than place funds in the markets at something lower than this. And they will not achieve a higher return for a commensurate risk because the system is awash with liquidity, and prospective borrowers are surrounded by the hidden shoals of marked to model.

This works in the first wave of quantitative easing. But what happens when the Fed seeks to add additional tranches of funds through market purchases of even more dodgy assets, or even begin to exercise more control over the banking system as the economy recovers to avoid a hyperinflation? "Draining" through open market operations is not easy if the banking system is still more fragile than its nominal balance sheets would suggest. In a sort of Gresham's Law, the banks wish to hoard the Treasuries, and disburse their collateralized bundles. Pulling out Treasuries removes the core of their assets.

The Fed is now seeking a 'deposit rate' which in addition to its 'overnight rate' would commit banks to place funds with the Fed for a set period of time, in the manner of a certificate of deposit rather than a demand account.

This article from Bloomberg is an indirect pre-announcement from the Fed that they may abandon the notion of 'target rates' altogether, and set interest rates by fiat, rather than achieving them in the marketplace by adjusting levels of short term liquidity. This marks a transition from 'Phase I' to 'Phase II' of Bernanke's monetary experiment.

I want to emphasize the significance of this change.

This is becoming a pure 'command and control' economic financial engineering by the Fed, in which it sets rates by its decision, without engaging in market operations which could encounter headwinds against those policy decisions. It is similar in magnitude to the Fed monetizing Treasuries directly without subjecting interest rates to the direct discipline of the market. This is of a pedigree more in keeping with a command and control Five Year Plan than a market economy. Extraordinary times call for extraordinary measures the Fed and its apologists might say.

I do not wish to overstate this, but it also suggests that a continuation of the Fed's open market purchases would place an excessive strain on its own balance sheet, which has a much lower percentage of Treasuries than at most times in its history. One would have to wonder if the Fed itself could pass a stress test or a serious audit of the quality of its stated assets.

It is less costly for the Fed to pay interest directly on bank deposits and just set the rate, especially if they are in the form of time defined certificates of deposit, than if it were to continue buying up decaying financial assets to achieve its goals.

In a sense, the Fed is competing with commercial enterprise in 'borrowing' from the banks for its own balance sheet, to affect its policy measures. This is what is meant by setting a floor under the short term rates.

As an aside, I found this quote in the Bloomberg article quite to this point:

"By raising the deposit rate, now at 0.25 percent, officials reckon banks will keep money at the Fed and not stoke inflation by lending out too much as the economy recovers."

The level of reserves they are holding and the rate which they return through their interest program are being used to throttle lending to the commercial companies at market clearing rates. Granted this is all a part of a more aggressive and complex implementation of interest rate policy, but it presents a new level of financial engineering and explicit control of money flows that is quite likely corrosive to a market system, and fraught with unintended consequences.

The US Federal Reserve did not originate the concept of quantitative easing. It began with the Japanese central bank, which one might uncharitably say erred on the side of supporting the banks and the corporate conglomerates, and drove the economy into a protracted slump. There were, we should add, significant mitigating factors including the Japanese demographics and penchant for high savings at low rates in the government postal system.

This is an 'experiment' on the part of the UK and US in their own go at quantitative easing. The risk is obviously inflation, and they are seeking to downplay that at every turn. It is the perception of inflation that the Fed will seek to quell, as it continues to adjust the money supply in ways and with tools that it thinks it understands, but which it has never used before. Perception of inflation is their greatest fear. Once it takes hold it is difficult to stop.

One has to wonder what the anticipated endgame might be. A global currency regime with comprehensive central planning? Since 1999 the financial engineers at the Fed have been unable to achieve sustainable growth in the US national economy as is it is now constituted without generating asset bubbles through abnormally low interest rates. As recovery goes the last was anemic in terms of jobs growth, and this latest effort appears to be even more fruitless.

What does the Fed think will change if they can avert a crash again and maintain the status quo at the cost of yet another asset bubble?

Is the Fed trying to maintain an inherently unstable economic order that requires increasingly extraordinary means and ever greater imbalances to keep it from collapsing? I believe that they are.

Will the Fed have to keep assuming more and more power and control over the real economy to sustain the unsustainable until they destroy what they had intended to save? I think the answer is yes.

Bloomberg
Fed Weighs Interest on Reserves as New Benchmark Rate
By Scott Lanman

Jan. 26 (Bloomberg) -- Federal Reserve policy makers are considering adopting a new benchmark interest rate to replace the one they’ve used for the last two decades.

The central bank has been unable to control the federal funds rate since the September 2008 bankruptcy of Lehman Brothers Holdings Inc., when it began flooding financial markets with $1 trillion to prevent the economy from collapsing. Officials, who start a two-day meeting today, have said they may replace or supplement the fed funds rate with interest paid on excess bank reserves.

“One option you might want to consider is that our policy rate is the interest rate on excess reserves and we let the fed funds rate trade with some spread to that,” Richmond Fed President Jeffrey Lacker told reporters on Jan. 8 in Linthicum, Maryland.

The central bank needs to have an effective policy rate in place when it starts to raise interest rates from record lows to keep inflation in check, said Marvin Goodfriend, a former Fed economist. Policy makers are concerned that the Fed funds rate, at which banks borrow from each other in the overnight market, may fail to meet the new target, damaging their credibility and their ability to control inflation as the economy recovers.

‘Extended Period’

The choice of a benchmark is the “front line of defense against inflation, and also it’s at the heart of the central bank being able to precisely and flexibly guide interest-rate policy in the recovery,” said Goodfriend, now a professor at Carnegie Mellon University in Pittsburgh.

The Federal Open Market Committee is likely to maintain its pledge to keep interest rates “exceptionally low” for an “extended period” in a statement at about 2:15 p.m. tomorrow, economists said. The Fed probably won’t raise interest rates from record lows until the November meeting, according to the median of 51 forecasts in a Bloomberg survey of economists this month.

Fed Chairman Ben S. Bernanke, in July Congressional testimony, called interest on reserves “perhaps the most important” tool for tightening credit.

Inflation Concerns

Banks’ excess reserves, or deposits held with the Fed above required amounts, totaled $1 trillion in the two weeks ended Jan. 13, compared with $2.2 billion at the start of 2007. The Fed created the reserves through emergency loans and a $1.7 trillion purchase program of mortgage-backed securities, federal agency and Treasury debt.

By raising the deposit rate, now at 0.25 percent, officials reckon banks will keep money at the Fed and not stoke inflation by lending out too much as the economy recovers.

The new policy may be similar to what the Bank of England does now, said Philip Shaw, chief economist at Investec Securities in London. The U.K. central bank’s benchmark interest rate, now at 0.5 percent, is the rate it pays on the reserves it holds for commercial banks. It may drain excess liquidity from the system by selling back the gilts it has purchased through its so-called quantitative easing program, Shaw said.

Communications Strategy

Policy makers will need to adopt a communications strategy to explain the new benchmark because “people might have had a hard time getting their mind around the idea that the official rate had become the interest on reserves rate,” said Kenneth Kuttner, a former Fed economist who has co-written research with Bernanke and now teaches at Williams College in Williamstown, Massachusetts.

Without a federal funds target, banks might have to find a new way to set the prime borrowing rate, the figure most familiar to consumers that that is now pegged at three percentage points above the fed funds target.

In the past, the Fed had controlled the rate by buying or selling Treasury securities, adding or withdrawing cash from the system. That mechanism broke down when the Fed started flooding the system with cash after the bankruptcy of Lehman Brothers to prevent a financial meltdown.

The deposit rate would help set a floor under the fed funds rate because the Fed would lock up funds by offering a fixed rate of interest for a defined period and prohibiting early withdrawals.

‘Risk Free’

“In general, banks will not lend funds in the money market at an interest rate lower than the rate they can earn risk-free at the Federal Reserve,” Bernanke said in an October speech in Washington.

The New York Fed has been testing another tool, reverse repurchase agreements, as a way of pulling cash out of the financial system. In that case, the Fed would sell securities and buy them back at an agreed-upon later date.

There could be complications to using the deposit rate. Banks may be able to generate more revenue by lending at prime rate rather than by earning interest at the Fed, said William Ford, a former Atlanta Fed president at Middle Tennessee State University in Murfreesboro.

Also, the Fed’s direct control over a policy rate --instead of targeting a market rate -- could skew trading and financing toward short-term borrowing once investors know the rate won’t change between Fed meetings, said Vincent Reinhart, a former Fed monetary-affairs director.

The new reliance on reserve interest could also increase the policy clout of Fed governors in Washington at the expense of the 12 regional Fed bank presidents, Reinhart said.

Congress gave only the Fed governors the authority to set the deposit rate. The presidents have historically favored higher rates and voiced more concern about inflation.

“The Federal Reserve Act puts a very high weight on comity,” said Reinhart, now a resident scholar at the American Enterprise Institute in Washington. Using interest on reserves for setting policy “can change the tenor of the discussions, and I don’t know how they get around it.”