While shoppers were watching their pennies this holiday season, I was grinching over the relationship between the Fed and the big banks as reminiscent of the abusive relationship between Ike and Tina Turner – bail them out then beat them up with an onslaught of massive fines. According to a global banking study by the Boston Consulting Group, legal claims against the world’s leading banks have reached $178 billion since the financial crisis, with heavy fines now seen as a cost of doing business, a cost ultimately born by shareholders with no banking employees or executives facing charges for wrong-doing.
All these fines do little to deter wrong-doing in the future while taking money out of the hands of those saving for retirement and give it to the government to spend with zero accountability.
There was a time when no one, outside perhaps the most esoteric economic geek circles, could name the current Chairman of the Federal Reserve. Those days are now long gone as the Fed has taken a much more active role in the economy and the various Fed Presidents and Chairman have evolved into media cult figures, perhaps less riveting than the latest Kardashian marriage collapse, but financially far more provocative.
The Fed’s current focus is clearly helping Uncle Sam reflate out of the government’s enormous mountain of debt. The chart on the next page shows the mountain of debt that has been created by impressive levels of spending from both sides of the aisle for a truly bi-partisan mess. The deficit is now almost three times what it was seven years ago, while debt service costs are at about the same level, thanks to Fed sponsored suppression of interest rates. The Fed effectively has complete control of the market for longer-dated Treasuries, with its holdings of bonds with a maturity greater than 10 years increasing by $154 billion through June of this year, (latest data available from the Fed) to a total of over $500 billion. Meanwhile the total outstanding level of such debt, privately held interest-bearing, grew a measly $9.6 billion for a total of $809 billion.
For those of you who enjoy a monetary policy geek-fest, the following summary of comments from the various speakers at the Cato Institute’s Monetary Policy Conference on November 14th, including current Philadelphia Fed President Charles Plosser may be of great interest. I’ll do my best to keep it lively.
Charles Plosser opened the conference with a discussion of how many of the both implicit and explicit limits on central banks around the world have been challenged over the past few decades and most dramatically since the financial crisis. He believes the Fed entered into the realm of fiscal policy when it began purchasing non-Treasury securities such as mortgage-backed securities and referenced Milton Friedman’s warning in 1967 that, “We are in danger of assigning to Monetary Policy a greater task than it can accomplish.” Over the past 40 years, it is clear that we have failed to heed Friedman’s warning, with the Fed doing a poor job of aligning expectations with what it is actually capable of accomplishing. Plosser warned that increasing the scope of the Fed’s mandate opens the door for highly discretionary policies, acknowledging that a rules-based approach is unattractive for the majority of policy makers as it ties their hands.,Discretion is the antithesis of commitment, something most politicians loathe. If the Fed gave itself less discretion, it would be held more accountable. He pointed out that the current climate of guess-my-mood communication on the Fed’s part leads investors to make unwise gambles, as they try to read the mysterious tea leaves of Fed speak, such as the recent market tumult over taper talk.
Jerry Jordan, the former President of the Cleveland Federal Reserve expanded on Plosser’s comments, pointing out that the existence of a Central Bank with discretionary power essentially guarantees the emergence of moral hazard with the resulting power to grant permission and regulate with discretion, opening the door to crony capitalism. To large banks, their PACs, (Political Action Committees) are often more impactful on their bottom line than their own management. (Shocker, businesses as well as individuals respond to incentives!) He referenced the Fed’s recent report on the impact of quantitative easing on the economy stating that if there is any relationship between economic growth and quantitative easing, it is a remarkably well kept secret, instigating a round of chuckles from the audience. He pointed out that most economists understand that monetary policy cannot correct the mistakes of the rest of government, even though the Fed is currently doing its best to defy that assessment. He argued that central bank independence is a myth, at least during a financial crisis, because once a central bank takes its first steps to support the economy, there is no way out that does not involve collateral damage. That, by definition, prompts pressure from bureaucrats. He believes that exiting the current zero interest rate regime will be exceedingly complex and it will be impossible to escape without considerable financial market volatility. He seconded Plosser’s assessment of the Fed’s move into fiscal policy, asserting that traditional views of monetary policy and its impact are no longer useful as monetary policy has become fiscal policy. This move into fiscal policy has served to increase market volatility as no one can say with certainty, which entities will receive support during a crisis and for how long. Once again, discretion comes at a price.
Kevin Dowd, Professor of Finance and Economics, Durham University, reinforced John Allison’s assertions, pointing out that the original Federal Reserve Act is about 32 pages long. The Glass-Steagall Act is under 40 pages long. The Volker Rule is just under 550 pages. Dodd-Frank, so far, is nearly 850 pages with most expecting it to total around 20,000 pages or more when all the discretionary bits are worked out. Notice a trend in the timeline here? The more complex the regulations, the more costly it is to enforce them, and to comply with them, creating a bias towards ever larger financial institutions, and increasing the opportunity for corruption.
For those of you who’d like a bit more, aside from suggesting you look into therapy as my family reiterates every holiday, I recommend going to this site to watch clips of some of the presentations. Despite the gloomy potential, there were frequent rounds of boisterous laughter, albeit the geeky economist style which I enjoy more than I ought to admit.
The Federal Reserve has been under considerable pressure to provide details for just how it will control all the excess liquidity that it has created through quantitative easing. The Fed’s balance sheet, which can roughly be thought of as a proxy for the potential money supply, is almost 2.4 times the size it was in 2007. Last month I discussed how excess bank reserves have skyrocketed to nearly $1.7 trillion after having historically averaged near zero since the inception of the Federal Reserve. The Fed has argued that it will be able to slowly raise interest rates and carefully reign in those excess funds to prevent rampant inflation. This is something that has never in history been accomplished, so there is no clear roadmap for how to do this successfully, but for argument’s sake, let’s assume that the Fed is indeed capable. The question then becomes, “How will rising interest rates affect the economy and investing?” One of the largest impacts of rising interest rates will be on the financials of the federal government. The chart above shows the U.S. National Debt from 1950 to 2012 (left hand axis) and the annual deficit/surplus (right hand axis). The current national debt is over $16 trillion. Over the past 5 years, the annual deficit has averaged $1.4 trillion. The national debt as a percent of GDP is almost double what it was in 2007. The annual deficit is 9 times the size it was in 2007. The recent sequester cuts sent D.C. into apoplectic fits with dire warnings of impending doom, however those “cuts”, according to the Congressional Budget Office, represented a decrease in the amount of spending increase that is less than the total increase, which means there will still be an increase in net spending after the sequester, (see Congressional Budget Office “Final Sequestration Report for Fiscal Year 2013” published March 2013). Given the emotional hoopla and doomsday rhetoric, it is reasonable to assume that the current level of deficit spending is unlikely to decrease significantly anytime soon.
The current 10 year Treasury interest rate is about 1.8%. It reached its lowest level in July 2012 at 1.53% and the highest rate was 15.32% in September 1981 when Paul Volker put the kibosh on inflation. The historical average rate has been about 4.6%. The current annual interest payment on the debt is just over $220 billion. If interest rates were to rise to only the historical average of 4.6%, that would be an increase of 2.8%, which would be an increase of nearly $110 billion, if we assume for simplicity that all the new issuance is a 10 year terms. (The reality is that some would be shorter term, some would be longer, and this is just meant to give an approximation to illustrate the magnitude of the impact.) That means interest expense on the debt would increase a whopping 50% in the next year. If the deficit spending continued at about the same rate for the next 6 years, annual debt interest payments would become the government’s costliest expense by 2020. For every year that we continue to deficit spend, increasing the national debt, the magnitude of the impact of rising interest rates increases.
That puts the Federal Reserve into quite a pickle if the economy does in fact gets some legs and inflation ignites. Don’t raise rates and face punishing inflation. Raise rates and D.C. is going to be put under even more pressure to reduce spending. No wonder Chairman Ben Bernanke has been giving subtle indications that he isn’t keen on yet another term as Chairman!
It took the federal government around 200 years to accumulate a trillion dollars in debt. Within the following decade it tripled that number, then doubled it again in just twelve years, and doubled it again in another 8 years. Overall the national debt has increased sixteen-fold in just 30 years. Incidentally, this period coincides with the complete delinking of the U.S. currency to the gold standard.
So how are we managing all this debt? In 2013 the Federal Reserve will buy approximately 90% of the country’s issuance of Treasuries and mortgage bonds! That’s one way to explain how a nation facing such a growing mountain of debt, a slowing to stalling economy, and a paralyzed political process is able to maintain such incredibly low interest rates. Treasuries have long been used as the standard for the risk-free rate. With only 10%
of the issuance to float freely in the market, the Fed is able to generate considerable demand for this “risk-free” asset class, driving prices up, which means driving interest rates down.
The massive distortions from the various Quantitative Easing programs have damaged the market mechanisms for understanding the true price of risk, which gives markets an understanding of the appropriate cost of capital. A market that no longer can obtain this information has a big problem, because mispricing of risk leads to misallocation of capital.
The proverbial saying goes that markets love to climb a wall of worry. We’ve seen corporate earnings and revenue growth slow sharply through the past year, with corporate guidance for future performance continuing to be rather grim, yet equities have had quite a run. This is due to expanding P/E multiples as we discussed in last month’s newsletter. This expansion is 85% correlated to the Fed’s ongoing balance sheet expansion, as it is now adding about $85 billion of relatively secure fixed income securities to its $3 trillion portfolio on a monthly basis. Such an enormous level of buying in the markets, leaving only 10% of new issuance available for purchase, is forcing investors into other assets, pushing up prices.
How is this level of Fed activity going to end? David Rosenberg of Gluskin Sheff described the situation well by saying,
“I am concerned over the unintended consequences of these experimental policy measures that have no precedence, but perhaps these consequences lie too far ahead in time from a ‘tactical’ sense, but we should be aware of them. The last cycle was built on artificial prosperity propelled by financial creativity on Wall Street and this cycle is being built on an abnormal era of central bank market manipulation.” January 17th, 2013.
Bottom Line: When one looks over the past 12 years of active Federal Reserve monetary policy in which we experienced repeated bubbles followed by painful pops, why does anyone believe this time will be different? Particularly when this time we experienced monetary activism on an unprecedented scale: we are truly in uncharted waters.
On September 27th, Freedom Fighters Chris Cotter, Nancy Skinner, and Lenore Hawkins discussed the Fed’s plans to monitor the Internet, and why Coca-Cola is choosing China.
Today saw the dollar continue to drop, slipping to below 74 before closing at 74.27, getting closer and closer to the March 2008 low. In turn, commodities are making new highs with gold closing above $1,500 and silver above $46. The cyclically sensitive currencies like the Aussie dollar and the Canadian loonie are strengthening as well against the dollar. Even the Euro, with all its debt challenges is stomping on the greenback, apparently unaffected by all the talk of debt restructuring. Emerging market currencies continue to firm against the dollar and as one would expect, stocks rise against our falling currency.
We expect that the Fed will work out a way to extend its program of quantitative easing, possibly using funds from the maturing mortgages on its books. If this indeed does occur, the push into risk assets will most likely intensify and the trade deficit will decline.
This is a hilarious video on you tube talking about Quantitative Easing, Inflation, Deflation and the Financial Crisis. Enjoy!
We hear a lot of talk about which government policies can help get the economy back on its feet. I thought I’d provide a quick cheat sheet on just what these various terms actually mean.
This chart shows the complete list of tools that the federal government has to affect the economy. There are two main types of policy, monetary and fiscal. When you hear monetary policy think Federal Reserve. When you hear fiscal policy, think IRS and federal spending.
The Federal Reserve can alter two things to affect the economy, the Fed Funds rate and the Money Supply.
Interest Rates: The Federal Funds target rate is the interest rate at which private depository institutions, (mostly banks) lend the funds they hold at the Federal Reserve to each other, generally overnight. It can be thought of as the rate banks charge each other. This target rate is identified in a meeting of the members of the Federal Open Market Committee which usually meets eight times a year. The New York Fed affects this rate by trading government securities.
Money Supply: The Federal Reserve typically alters the money supply by increasing or decreasing bank reserves. (See prior post on Fractional Reserve Banking for details on bank reserves.)
Tax and Spend: What else need be said? Fiscal policy involves the government increasing or decreasing taxes and the amount of federal spending, which let’s face it, pretty much just goes up.