Saturday, September 12, 2009

Federal Reserve's Kohn: We Plan to Keep Throwing Kerosene on the Fire

Ok, that was not his exact quote.... but you get the idea. They say "never to fight the Fed". I had doubts on that quote in the past, but what the Fed used to do in the past was child's play compared to what it is doing now.

I cannot emphasize enough that Ben Bernanke, being a student of the Depression, believes the #1 error of the time was applying the breaks to easy money policies too early. What that means in modern times is, until it is abundantly clear a very real recovery is here, the kerosene of easy money will continue to be thrown onto the fire. I am seeing the same words coming from Tim Geithner and Larry Summers. Besides the fact it is always more politically convenient to give away free punch than to take it away, this is a universal thread in all their comments. John Paulson believes it. [May 16, 2009: John Paulson Continues to Pile Into Gold] Marc Faber believes it. We need to believe it.

In layman's term, we have this big hole of debt - it is contracting onto itself as Americans (a) try to do the right thing and pay down their debt (b) consumers as a whole are too weak to spend on their own like in the "good ole days" and (c) banks actually act rationally in giving out loans because the securitization market [where they got rid of most of their loans the past decade, to suckers who believed in AAA ratings] has taken a near mortal blow. Now that banks have to hold more of the loans, they actually seem to care about the propensity to be paid back - our "financial innovations" of the past decade had let them avoid that old school concept. So with the crippling of the securtization market, there are no more new suckers to offload these loans to; so until new ones are borne, there is only one sucker. The Federal Reserve which has BECOME the securitization market.

So we have this hole of credit contraction described above (deflationary)- and a Fed who wants to fill this hole (inflationary). A great battle ensues - but the Fed has the means to endlessly (in their eyes) fill the hole. It's called a printing press and its sugary properties makes all the pain go away to the people - at least in the near term. (see NASDAQ bubble 1999, see real estate bubble 2004-2007) So everyone applauds said printing press operators - just as they did in the late 90s, and mid 00s. But the currency suffers... and suffers... and suffers. (note US dollar performance since leaving the gold standard) And so do living standards for the majority who live under this regime who believes inflation (the loss of buying power) is the "righ thing".

Further there is no control in what this kerosene lights up. Obviously the powers that be want the economy to magically take flight despite a real unemployment rate at roughly 14 percent and underemployment closer to 20. The federal government is trying to take care of that (minor) issue via generational arbitrage...take from future generations to buy cars, homes, cut taxes, plug holes in state budgets for today's generation. But end demand is still relatively poor despite the handouts. Yet all that liquidity needs a home...and like water it will find its level in 1 place or another. If not needed in the real economy, it will plow into the Wall Street economy. And selective inflation in speculative assets can occur...even if concurrent deflation in parts of the real economy is occurring. Therefore, short of a rebirth of the US consumer in the very near future - this seems to be our path.

VP Kohn reiterates the viewpoints above... the hole will not only be filled but we are going to top it off. And only then will the punch bowl be even considered to be taken away. Which is why I was scoffing about 2 months ago when the "fed funds futures market was indicating a chance of tightening by end of year 2009". What world do these people live in? So it's not Helicopter Ben, it's not B52 Bomber Ben - we now have Kerosene Ben. He is an arsonist of the highest order... and Wall Street loves a good fire. When the fire reaches 50 feet high, he will still be pouring kerosene on to make sure it doesn't peter out prematurely - only 100 feet will do. Because that's just what he (and his predecessor) do (did).

In the meantime many a new bubble will be created. (they will be celebrated by the speculator class) And then we'll have a crash when all the oxygen has been used up. And then a new hole will be created from the crash, (does any of this sound familiar?) and then the Fed will create more punch later in the next decade. And we will stupidly ask how did we get here again. This pattern will continue because we refuse to take the pain of our excess even once. We are above pain because we are a special people.

It will only stop when our creditors say "enough!" Creditor #1 (China) is taking step after step to show us they won't be part of this pattern in about 10 years. They are stuck playing along for now. Everything you have seen thus far the past 2 years... as spectacular as it has been... will pale in comparison to the banana republic tactics we should see happening in the late 2010s and early 2020s. We are in the largest economic experiment in mankind, led by people and institutions who have made error after error, and in return are being given even more power. Surely that will work out "in the end".

But between now and then? Perhaps 2 more massive bubble and bust cycles can be created. "They'll" call it prosperity. Those of us outside of the Matrix will see the truth. To that end, we already see pieces such as "10 Bubbles in the Making "

Via Reuters
  • Federal Reserve Vice Chairman Donald Kohn said on Thursday the U.S. central bank was developing tools to move away from its extremely loose monetary policy, but such an exit would not happen any time soon.
  • "As the FOMC has said, that time is not likely to come for an extended period," he said, referring to the Fed's monetary policy-setting Federal Open Market Committee.
  • The paper, on the Fed's track record since the failure of investment bank Lehman Brothers at this time last year, noted the central bank's massive expansion of its balance sheet would not lead to inflation due to its ability to pay interest on reserves that are held with it by commercial banks. (that is where you laugh) "Paying interest on reserve balances also has important benefits and will play a key role in our exit from unusually accommodative policies when the time comes," Kohn said.
  • Critics say the doubling in size of the Fed's balance sheet to around $2 trillion since last September will lead to higher consumer prices when growth picks up and banks begin to lend out these excess reserves, fueling another credit bubble. But the Fed argues that its ability to pay interest on reserves will break this linkage.
  • "Raising the interest paid on those balances should provide substantial leverage over other short-term market interest rates because banks generally should not be willing to lend reserves in the federal funds market at rates below what they could earn simply by holding reserve balances," Kohn said.
  • This position was supported in the paper by Columbia University economist Ricardo Reis. However, he did caution that the increase in the balance sheet was not without risks, and warned that if this led to credit losses at the Fed, it could force the Fed to go hat in hand to the U.S. government, compromising its policy independence. (that would actually be amusing, considering the US government has been going hat in hand to the Federal Reserve)
  • Kohn added this outcome "seems extremely remote," and he argued that the Fed would continue to earn substantial net profits on its balance sheet for the next few years in all but the most distant scenarios. (other things that once seemed 'extremely remote' - housing prices falling nationally in the US, AAA rated securtizations blowing up all over the globe, monster bailouts of financial institutions that were not even on the FDICs troubled bank list, AAA rated AIG being a ward of the state, Goldman Sachs needing to hide under the umbrella of the FDIC.... shall I continue?)
  • "Short-term interest rates would have to rise very high very quickly for interest on reserves to outweigh the interest we are earning on our longer-term asset portfolio. With the global economy quite weak and inflation low, a large and rapid rise seems quite improbable," Kohn said.
Surely this grand experiment will all work out in the end; one need only look at the track record of this fine institution since Volcker (who actually took away punch) left.

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