Last week, the Fed took a very dramatic step in providing some relief to the ailing economy, by creating money to buy bad assets of the crumbling financial institutions. Last week the Fed bought $5 billion of Freddie Mac, Fannie Mae, and Federal Home Loan Bank corporate debt.
Okay we know the Fed had been printing money, but prior to this, the Fed swapped out bad assets with treasury bonds, which is not an impressive move either. A better way to think about the new scheme is that the Fed magically increased account balances by a couple of billion dollars. You may pause to think why; could the situation be that bad that it calls for a panic? Well the idea was that by doing this, they can create credit that will be loaned out for people to re-finance. How’s that different from all the other credit injection schemes? The difference is this, the old scheme acted as a pawn shop to the financial institutions (well, almost like considering the assets the financial institution owned were worthless), and with this new scheme the Fed is “giving it out”. Now which cash infusion are you likely to spend thoughtlessly, the “free money” or the pawn shop cash? Exactly what I thought, the free money!
So what’s the point here? $50 billion may be a small number giving the size of the Fed, but like everything else that comes from the Fed, it’s a teaser, what happens when that figure is multiplied by 10? Being free money, it is loaned out freely, and economics teaches us that when money becomes cheaply available, everyone wants more for stuff, and then inflation kicks in. The blinding battle now is the battle against deflation, oil prices have crumbled to about a third of its highs last year, CPI numbers show YoY decline, highest level of joblessness seen in years, the Fed is using all its guns to fight “deflation”, but like every monetary policy that comes from the Fed, there is always the issue of latency.
This week we should see the outcome of the last FOMC meeting for the year, and the market expects a 50 basis point cut. Short term treasury yields are sitting at close to zero. Hence, another tool that may be used by the Fed to fight this battle on deflation is by debasing the dollar. By increasing the availability of US dollars, making it very cheap, the US can cause buyers within its market (we saw a little bit of this last year with Europeans flying into the US to shop). So why is this a suspect now, firstly it has been done before, secondly given the recent actions of the government it wont be above them to do so, thirdly the US dollar has been falling steadily for about two weeks now. Bernanke has clearly stated that he will do everything to fight deflation.
Many analyst proclaim that the condition will get much worse, and some make the case that there is the likelihood of some 1930s kind of incident, I don’t have a crystal ball, but I like to be optimistic, so I say that things are going to take a reverse course, and begin to get better in about 6 months, for a more technical view see here, and in this recovery process we just may witness the Fed fighting a new beast next year, well maybe in 2 years.
Lest I forget, the total amount of Federal Reserve bank monetary base has increased twofold in three months, see http://research.stlouisfed.org/publications/usfd/page3.pdf, that’s what you call a printing press!
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By recucing interest rates and increasing the supply of money, people have incentive to spend and invest, not park, cash. This will increase economic activity eventually, but the problem is it will take time.
I look at this situation like a bunch of people creating a human pyramid. As it grows, some can say “it’s growing too big”, but rather than argue their point, they just cut back on oxygen in the room. After awhile, people get whoozy, and less likely to climb on the pyramid. Now, someone says “looks like they’re getting a little whoozy, we should turn the oxygen back on”.
However, someone collapses. This causes others to collapse. Someone says “make sure the oxygen is full on!”. Now, when do the people start making their pyramid again? And, when they don’t jump right up, someone says “hey, the oxygen isn’t doing the trick, perhaps we should moderate it again because when they do get up, they’ll go crazy building their pyramid!”.
Here’s what needs to happen- jack up the oxygen, put masks on a few climbers, and then PROMISE YOU WON”T TURN OFF THE OXYGEN AGAIN!. You may have a chance to get things going then- but it will take time.
Sadly, what may take awhile to build can crumble in an instant. If we want to have an honest debate about why we may need to ration limited resources (maybe constraining birth rates as in China)- well then let’s have that debate. But we, the American people, have to make sure our Fed doesn’t pull the rug out underneath us next time our economy reaches peak production.
Dirk,
The game is House Of Cards where you want everyone to believe you that adding a new deck to the stack is the solution