The Fed's Massive Conflict of Interest

What explains the Federal Reserve's reluctance to raise rates today? The conventional wisdom is that the economy remains soft and inflation hasn't yet shown signs of increasing. While both of these points are to an extent true, the soft economy could well be at least partly due to the serious hit that retirees have taken to their portfolio of fixed income investments, including the near-zero income they've earned on their typical Certificate of Deposit portfolios for the past six years.

Meanwhile, the current administration continues to pile regulation upon regulation to hamstring healthy industries while doing little to encourage economic activity otherwise.

As for inflation, it clearly hasn't spiraled out of control as feared by many monetarists, including myself, although I will argue in a future post that the Fed has relinquished its control over the price level by implementing its recent policies of paying interest on reserves, driving the fed funds rate to near zero, and expanding excess reserves into the trillions (from a few hundred million dollars previously, skipping right past the billions.)

The Conflict the Fed Now Faces: Huge Losses When Rates Go Up

First, let me say that I'm not going to do the sort of research that needs to be done to accurately quantify my claims here. No one is taking this issue seriously yet, so that level of examination of the problem is not yet needed. Others will do it should this conflict finally be taken seriously.

It's sufficient to say that the Fed's current portfolio of long-maturity debt instruments will take a significant hit if they ever return short rates to a reasonable level of, say, 5%. On a long treasury, the hit could be on the order of 25% to 35% of the Fed's original purchase price. And if inflation were to head toward 5% the resulting 8% or so rate on long treasuries could drive the loss to well over 50% of their purchase price.

If we assume the Fed's portfolio has $3 trillion of long securities subject to just a 25% loss in value from their purchase price, the loss would be $750 billion. Now, the Fed has been making money for the past several years by means of a massive carried interest trade since they've effectively financed their long portfolio with funds bearing almost a zero cost, i.e., the fed funds rate. Again, assuming a $3 trillion portfolio yielding, say, 3%, would mean that they've been clearing almost $100 billion per year on their position.

Incidentally, one argument that could be made for the Fed's reluctance to raise rates the past few years it that they want to bank that $100 billion per year for as long as possible so that they have a defense against the criticisms they will receive  over their inevitable losses when they someday are forced to raise rates.

Interest on Reserves Will Aggravate the Losses

The conflict deepens when the relatively new policy of paying interest on reserves is considered. There are only two obvious ways to neutralize the impact of over $2.5 trillion in excess reserve in the banking system. The Fed can either drain them or pay banks to continue to hold them.

Obviously, if they attempt to drain the reserves, they will have to commence selling their massive long portfolio. Such an action would further drive down prices of the securities they still hold, deepening the losses described above.

More likely, however, the Fed will decide to continue paying banks to hold their excess reserves. Currently banks receive a nominal rate, 0.25% (1/4 of one percent) to hold the over $2.5 trillion in excess reserves. That still amounts to a cost to the Fed of over $6 billion a year, however. But if the Fed were to raise rates by 1%, to 1.25%, each increase of said 1% will cost the Fed $25 billion in fees they would have to pay the banks to continue holding their excess reserve balance. Otherwise, they would simply sell them in the fed funds market.

Of course, banks attempting to liquidate $2.5 trillion in reserves they don't need would drive the fed fund rate back to zero again. Therefore, the Fed absolutely must either drain those reserves or pay the banks a high enough rate to continue to hold them. Thus, a 5% funds rate would imply that the Fed must assume a $125 billion annual operating expense if they are to neutralize the current excess reserve balance.

Conceivably, the Fed could do a massive reverse repurchase operation wherein they would lock in a longer-term rate for a time, alleviating the initial impact on their income statement. That is, they might convince the banking system to hold, via a, say, one-year repurchase agreement priced at 1%, the Fed's security portfolio, thereby draining the excess position for a year at a cost of only $25 billion. However, if rates at the end of that year were, say, 5%, the cost of a repeat operation would put the cost up to the $125 billion level for the following year.

Conclusion

The Federal Reserve has created a situation, via the various QE's, that now saddles it with a massive conflict of interest should they need to raise rates. That conflict is comprised of two parts, both parts amounting to hundreds of billions of dollars each in conceivable costs to the Fed.

It would not be at all hard to conceive of a situation in which the Fed's long portfolio is $500 billion underwater all while they are paying the banking system over $100 billion per year to neutralize the excess reserve position they generated when purchasing that long portfolio. One would think that prospect has received some internal consideration when the discussion of raising the fed funds rate comes up.

What is surprising is the lack of any such consideration in the financial markets and the political world. This is especially ironic since it has been the U.S. Treasury's intent to lengthen the maturity of the public debt at this time of exceptionally low interest rates, and yet the Fed has effectively reversed that decision by implementing its massive QE's.

Sadly, the policy hasn't even worked out as intended, enriching bond investors, stock investors, art investors, and real estate investors, but doing little to get the economy and the job markets growing again. And yet it continues. Perhaps the above-described conflicts have more than a little to do with that?

Beginning Again

It's been over six years since the last post I made here at OnTrack Economics. Whether this post is the beginning of a new series, we'll have to see, but if it is here's what I hope to accomplish:

1. Explain what has happened to monetary policy options since my last post in 2009.

2. Explain the box the Fed now finds itself trapped within.

3. Explain the theory of monetary policy that the Fed abandoned.

4. Describe a better, strong form theory of monetary policy that should be used instead.

5. Attempt to explain how the former monetary policy control levers might be restored, in time. 

Changes in Monetary Policy Since 2009

Taking point #1 as the remainder of this post, the Federal Reserve essentially abandoned the normal means of controlling total reserves and the money supply when it

a) started paying interest on reserves,

b) allowed the fed funds rate to go to essentially zero percent, and

c) instituted the process of Quantitative Easing that goes by the acronyms QE1, QE2, and QE3.

Interest on Reserves

When the Fed started paying banks interest on the reserves they hold to back deposits, they in effect disabled their ability to generate controlled monetary growth. Prior to doing so, a small change in the balance of excess reserves in the banking system, on the order of a few hundred million dollars, always affected the amount of money in the banking system. Today, the existence around $2.5 trillion of excess reserves in the banking system clearly indicates that the system no longer reacts to the level of excess reserves.

Driving the Funds Rate to Zero

The Fed, and many monetary economists as well, assume that there is a zero boundary problem that crops up whenever the economy will not support a positive interest rate. When, no matter how low the Fed drives the fed funds rate, the money supply and economy fail to improve, zero is eventually reached, according to this thinking. And at the zero boundary it is no longer possible to drive rates lower, so the Fed loses it's ability to grow the economy by driving an increase in the money supply.

Side note: In fact, after several years of zero rates now, some central banks have indeed learned that rates can drop below zero with the proper inducements, such as charging a fee for holding deposits, rather than paying interest. This is a novel concept, sort of a new and improved mattress, if you will. That is, don't put that billion dollars under your mattress where you could lose it. Instead, deposit it with us and we will ensure that you get at least 99.5% of it back in one year's time. Well, a billion is a lot to mess with, so some institutions have done just that.

And still, monetary policy has been frustrated. What to do?

Enter the QE's, #1, #2, and #3

Finally, the powers that be at the Federal Reserve decided that if you can't get the economy revived with a zero short rate, then they should get to work on long rates. The net result is that the Fed's portfolio now contains trillions of dollars in long maturity debt including the lion's share of most long maturity U.S. Treasury issues.

But while Quantitative Easing has done wonders for the stock market, the bond market, the art and other collectible markets, and has even got houses selling like it's 2006 again, the economy remains soft and inflation shows no sign of accelerating, thereby giving the Fed little reason to raise rates under its monetary model.

Conclusion

Unable to justify a continual transfer of the bulk of the long treasury market to the Fed's portfolio given the failure of three such episodes to generate economic growth, and unable therefore to justify a return to a more normal level of fed funds, the Fed just sits and waits, promising that a tiny rate increase will be due soon. (The definition of "soon" is apparently somewhat loose at today's Fed, however.)

The next post will explain the box that the Fed now finds itself trapped within, and why "soon" really means "not until we really have to."

Stock Vigilantes to the Rescue

During President Clinton's terms of office we had the Bond Vigilantes. They rode herd on the government by raising interest rates whenever spending plans threatened to get out of hand. Today, with interest rates on U.S. Treasuries near record lows, the Bond Vigilantes have been overwhelmed by a desperate flight to safety by millions of frightened investors. But a new vigilante group has arisen to take over, the Stock Vigilantes.

For several weeks, it seemed that every time President Obama opened his mouth to explain a new, far-reaching government program he was planning, the stock market would take another 100 to 200 point dive. On the off days, Pelosi or Reid would add their thoughts and stocks would dive again. Then a strange thing happened. President Obama's poll numbers started first to fall, and then to plummet.

What we now have is a President frightened by his popularity dropping and realizing that millions of Americans, and not a few foreigners, are blaming his policy pronouncements for each additional 2, 3 or 4% daily drop in their retirement plans. That is, the Stock Vigilantes have taken control from the Bond Vigilantes.

It's no coincidence that President Obama recently decided he needed to hedge somewhat on the implementation of "Cap and Trade" legislation. Every time he raised the issue, the Stock Vigilantes took another chunk out of our retirement plans. When word surfaced that he was becoming ambivalent about pushing the most far-reaching restructuring of the American economy since FDR's New Deal, we finally had the best market rally of the year.

This President wants to take America down a far-left socialist road. Of that there can now be little doubt given his policy pronouncements since Inauguration Day. And it's unlikely that a drop in the polls will stop him. But Congress has another election day scheduled in a year and a half, and campaigning will begin soon. The Stock Vigilantes don't have the power to turn President Obama into a moderate, but they do have the power to scare moderate Democrats, and probably even a few liberal ones, into reining in the president's more radical aspirations, each of which promises to drive the American economy further southward.


Economic Forecast

As I said on December 2, the economy would hit bottom by March and certain leading numbers including retail sales and durable goods orders would rebound first. Employment would lag by a month or two, but would be the number that ultimately convinces the markets that the economy is turning upward. So far, both January and February's retail sales figures have come out stronger than expected. Though January's figure failed to ignite any enthusiasm, when the February decline of .1 percent (versus an expected decline of .5 percent) was reported along with a significant upward revision to January on March 12th, the market added to the rally it began on Monday, March 10th.

Durable goods orders, on the other hand, were still plummeting as of the January number, reported on February 26th. The February number to be reported near the end of March should begin to show a turnaround, however. The employment number remains dreary, and will not show strength until the numbers for March are reported in early April, or possibly even a month later. Nonetheless, the economy appears now to me to be turning on schedule, as I wrote in early December. Interestingly enough, a poll at CNN on when the economy would recover offered no option for "soon" or "now" and only 22% of respondents even chose the "later this year" option. The other 78% are looking for the recession to last until the end of this year at least.

The Bond Market

Rates plunged to absurdly low levels after my December 2nd forecast with the 10-year note yield falling to nearly 2 percent from the 2.70% rate in early December. That rate was unsustainable and 10-year rate is now back up near 3%, fluctuating between 2.75% and 3% lately. The long bond dropped from the early-December number of 3.25% to a low of near 2.5% in late December and is now back up, trading between 3.5% and 3.75% for the past month or so. As the signs of a strengthening economy mount, long term government securities are going to be slaughtered, especially given the massive borrowing that is going to be required to finance recent spending bills. And this is before inflation becomes a major concern, a factor that will likely come into play later in the year depending on Federal Reserve actions over the next several months.

The Stock Market

My December forecast on the stock market failed to account for the willingness of President Obama to destroy wealth by jettisoning the capitalist system, or at least expressing his intentions to do so, at the first opportunity. Otherwise, it's likely the lows made last November, which were then tested in January, would have held. Instead, investors lost all hope that the economy would be managed for growth and the market plumbed new lows. Only in the last week, when President Obama expressed a sentiment, and only a sentiment, that perhaps some of his ideas might have to wait for the economy to recover, did the stock market put in a convincing rally. However, this president has shown a remarkable ability to be able to say one thing while doing the opposite but not getting called to account for doing so. It remains to be seen what he actually does next, but my money would be on further attempts at wealth destruction. As I said at the outset of this piece, only the Stock Vigilantes are likely to be able to bring this process under control, and then only by scaring moderate Democrats facing re-election in 2010.

We should have seen a significant stock market rally by this point, and maybe we still will. However, this president and this Congress are not the investor's friends. Forecasting a bull market, however much the fundamentals will justify one (and they will) is a fool's game with the present crew in charge. At least that's how I see it.

The Housing Market

Face it, housing has been beat up beyond most people's (though not my own) expectations. While it might have further to drop, and while inventories remain plentiful, it's probably time to start picking and choosing if one is looking to get into a house near the bottom. Housing markets are local, and some markets no doubt still have much farther to fall, but in general if a potential buyer puts in exceptionally low bids on several houses over the next few months, and ends up buying one, I suspect he will be satisfied with his purchase a couple of years later. This will be particularly true if the Fed lets the recent monetary burst remain in the system.

The Federal Reserve and Money Supply

The massive injection of funds into the banking system in September of last year resulted in over a 50% growth in demand deposits over the four months through December (from $300 bn in August to $465 bn in December.) That injection is now being wisely withdrawn and the February number came in at $397 bn. If monetary policy is not to generate a 25% or so increase in the general price level over the next few years, the Fed must draw down demand deposits to close to the $300 bn level over the next few months. If they do this over the summer, a historically weak period for the stock market, the process could be hard on stock prices. Nevertheless, it must be done if inflation is to be held at bay.

As I said in early December, the massive reflation by the Fed could "turn on a dime" and so it did. Within a month they had taken action that significantly contracted demand deposits. As a reminder, for a reader to fully understand this process, you must read and understand the seven "priority" posts on this site.

Another Note to Business Leaders

I asked in December if it would be useful to know that the economy would be turning up by the second quarter of this year. You now have a huge advantage over market participants. This is because you can see your own sales trends and how your customers are acting. If the economy is indeed picking up, you will see it in your sales (unless, again, you build houses.) The problem is that given all the gloom and doom talk, including that coming from the White House, you might not believe what you're seeing. Let me tell you this. If your customers are starting to show signs of perking up, it's real. The time to batten down the hatches has passed. Don't sail into an economic recovery with a shrunken sales force and with your manufacturing operations unprepared to ramp up production, or you'll be caught unprepared yet again. Trust what you're seeing in your own operations, not what you're being told by outside economists because they will miss the turn by several months.