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The Fed's In A Bind: The Cluelessness Of The Macroeconomic Establishment

Tyler Durden's picture




 

Submitted by Alasdair Macleod via GoldMoney.com,

One can understand the Fed's frustration over the failure of its interest rate policy, and its desire to escape the zero bound.

However, since the FOMC has all but said it will increase rates at its December meeting, events have turned against this course of action. The other major central banks are in easing mode, and the slowdown in China has further undermined both world trade flows and commodity prices. The result has been a strong dollar, which has effectively eliminated any perceived need for higher dollar interest rates. Meanwhile, the US's non-financial economy remains subdued.

Last August, a similar situation existed, when the FOMC signalled that a rise in the Fed Funds Rate might be announced at its September meeting. Ahead of it, China revalued the dollar by announcing a small devaluation of its own currency, taking the wind out of the Fed's sails. While the talking heads saw this as a failure of Chinese financial policy, it was nothing of the sort. Given the US was dragging its feet over the yuan's inclusion in the SDR, it was a salvo in the financial war between the two states, and the Fed found itself in the firing line.

Since then the pressure has been mounting from the IMF for the US to back down over the SDR issue. The result was announced only last week, with the dollar content hardly changing and the yuan being accommodated mostly at the expense of the euro from September next year. However, despite the SDR issue having been dealt with for now, the Fed appears to have very little room for manoeuver before higher interest rates will give rise to a new financial crisis.

The chart below illustrates the problem. It is of the Fed Funds Rate since 1980 and the Fiat Money Quantity, which simply put is the sum of the commercial banks' reserves at the Fed, plus cash and sight deposits held at the banks.

From the mid-eighties, successive interest rate peaks (the pecked line) have declined to the point, which if the trend continues, would indicate a Fed Funds Rate peak today of roughly 3%. It is clear that the reason for this declining trend is the increase in bank-related debt, the principal counterpart to FMQ, and the interest burden it places on borrowers.

This trend of declining interest rate peaks was established before the Lehman crisis, when the Fed's response was to rapidly expand its balance sheet. The result is FMQ growth accelerated from a compounding annual rate of 5.8% to 14%, taking FMQ to 70% above the previous long-term trend today. It would therefore require a far smaller increase in interest rates than indicated by the pecked line to tip the monetary system into a crisis, perhaps a Fed Funds Rate of as little as 1%.

The idea that we can be so precise about interest rate levels is obviously nonsense. If the Fed increases the Fed Funds Rate even slightly, non-financial borrowers often end up paying a significantly higher rate that includes a larger interest rate spread. The spread between interbank and corporate borrowing rates becomes an important indicator of financial stress, and junk bonds are already signalling deteriorating borrowing conditions. Just the threat of higher interest rates could turn out to be destabilising for the financial sector.

A problem of the financial sector's own making

The key metric which has permitted debt to increase at such a pace is the declining rate of price inflation. This rate has not responded to monetary inflation as one would expect, having continually fallen from the high rates of the late 'seventies, while the quantity of money and credit has increased significantly. The reason the rate of price inflation has declined is that by taking over the securities industry in the 1980s, the banks have been able to combine their licence to create credit out of thin air with the direct application of this credit into financial instruments. The result has not only been extremely profitable for the banks, but it has diverted excess credit from less profitable non-financial activities.

This partly explains why banks have increasingly neglected commercial and retail customers, concentrating capital allocation into investment banking. The effect has been to generally confine price inflation to assets, such as stocks, bonds and property. At the same time consumers have been packaged through securitised bulk lending for mortgages, student loans, credit cards and motor loans. Any pretence that banks exist to provide a service for customers has flown out of the window.

At the same time, this credit and securities duopoly has given the banks the ability to magically create paper substitutes for physical commodities through the futures markets, suppressing prices to levels below where they would otherwise be. In turn, this has reduced the pressure on price inflation for consumer goods. The decline in price inflation over the last thirty-five years is therefore the combined result of suppressed commodity prices, the reduced expansion of credit available to non-financial sectors, as well as favourable changes in statistical methods.

A declining trend of interest rates has been crucial for the profitable expansion of financial activities for their own sake. Since assets are valued with reference to interest rates, the falling trend in interest rates since the mid-eighties has delivered large profits to the banks and their financial customers.

The ground-level which inhibits further credit expansion is zero interest rates, a condition that has existed for seven years. Despite talk of negative rates, the impetus lower interest rates give to expansion of the financial side of the economy has already come to an end. Attempts by the Fed to raise interest rates, even slightly, should be considered in this light.

The next financial crisis could manifest itself in the coming months. The time-line of monetary expansion reflected in the chart above is at risk of being terminated by events. If so, it will mark the end of current central bank monetary policies and state control of markets, as free markets reassert realistic pricing. Government bond yields will normalise, stock markets will fall, and banks will almost certainly fail. Supressed commodity prices will rise as banks, short through paper contracts, will be forced to close their positions. Credit default swaps, where the banks are collectively exposed to losses when interest rates rise, will be a further source of grief.

When something as epochal as this happens, we can expect the macroeconomic establishment to be clueless with respect to the problem itself and its scale. Central banks will naturally revert to the Lehman remedy of further monetary expansion to cover the losses, whose enormous scale will not be apparent at the outset. This time, not only will the fiat money quantity accelerate into hyper-drive, it will be impossible to maintain the purchasing-power of the world's reserve currency, therefore threatening that of all the others.

This month's FOMC rate decision will not change this outlook, but it could bring forward the timing.

 

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Thu, 12/10/2015 - 15:04 | 6905778 stocktivity
stocktivity's picture

It's all Bullshit!!!   Dow up triple digits.  Rally on...

Thu, 12/10/2015 - 15:11 | 6905814 Manthong
Manthong's picture

I like Alasdair, but holy smokes,,

I think the Fed would have .gov go door to door confiscating everything of value prior to the time it would allow a free market to function again.

 

Thu, 12/10/2015 - 16:48 | 6906533 JRobby
JRobby's picture

"go door to door confiscating everything of value"

That would result in a large number of "door to door" confiscators shot dead, No?

Thu, 12/10/2015 - 15:23 | 6905905 Id fight Gandhi
Id fight Gandhi's picture

It's going to be rally on when they don't raise rates next week

Thu, 12/10/2015 - 15:06 | 6905780 aliki
aliki's picture

quick - turn on CNBC ... the "female, oil-version of dennis gartman" is on explaining why she's still wrong(er) on the price of oil

just waiting for her to say "LIKE OH MY GOD YOU GUYS ... TOTALLY!!!"

Thu, 12/10/2015 - 15:14 | 6905847 Dr. Engali
Dr. Engali's picture

The only thing that the fed is frustrated with is the fact that they haven't been able to drain all the wealth upwards fast enough before the whole system resets by planned demolition. Pull it bitchez! 

Thu, 12/10/2015 - 15:24 | 6905906 Pareto
Pareto's picture

OT  Janet's buying the market.........................again.

Thu, 12/10/2015 - 15:25 | 6905914 jose.six.pack
jose.six.pack's picture

Boring article. Show me crude crashing! 

Thu, 12/10/2015 - 15:28 | 6905930 lunaticfringe
lunaticfringe's picture

Everything is fine. JP Morgan says so. Read this and try not to puke on your computer screen

https://about.jpmorganfunds.com/insights/5-myths-about-u-s-government-de...

Thu, 12/10/2015 - 15:28 | 6905942 DrData02
DrData02's picture

Not "in the firing line", "in the line of fire".

Draw your own conclusions.

Thu, 12/10/2015 - 15:33 | 6905979 PoasterToaster
PoasterToaster's picture

Macroeconomics is a Keynesian perversion of the true study of individual economic decisionmaking.  The idea that government has a duty to micromanage people's lives is part of the reason Keynesianism is a scourge that must be removed from society.

Thu, 12/10/2015 - 15:52 | 6905985 Batman11
Batman11's picture

Banks create money out of nothing.

All they have to do is lend it out, charge interest and make a profit.

There is only one task they have to undertake and that is to lend prudently to people who will pay them back.

Could it be any easier with no manufacturing, supply and distribution chains to worry about?

What are bankers like at prudent lending?

“What is wrong with lending more money into the Chinese stock market?” Chinese banker recently

“What is wrong with lending more money into real estate?” Chinese banker last year

“What is wrong with lending more money to Greece?” European banker pre-2010

“What is wrong with a NINA (no income no asset) mortgage?” US banker pre-2008

“What is wrong with lending more money into real estate?” US banker pre-2008

“What is wrong with lending more money into real estate?” Irish banker pre-2008

“What is wrong with lending more money into real estate?” Spanish banker pre-2008

“What is wrong with lending more money into real estate?” Japanese banker pre-1989

“What is wrong with lending more money into real estate?” UK banker pre-1989

“What is wrong with lending more money into the US stock market?” US banker pre-1929

 

Fucking useless.

 

Thu, 12/10/2015 - 15:47 | 6906073 Hohum
Hohum's picture

Newsflash: US federal deficit for FY 2016 bigger YTD than 2015:

https://www.fiscal.treasury.gov/fsreports/rpt/mthTreasStmt/mts1115.pdf

Why isn't it, ahem, shrinking?

Thu, 12/10/2015 - 16:25 | 6906383 LawsofPhysics
LawsofPhysics's picture

Yikes.  Looks like the destruction of our own energy and commodity sector wasn't such a good idea after all?

Usless fucking paper-pushers and their fucking political puppets.

roll the motherfucking guillotines, nothing changes otherwise!!!!

Thu, 12/10/2015 - 16:52 | 6906555 JRobby
JRobby's picture

Because spending is increasing at a rate that is faster than the rate that tax collections are increasing

Next

Thu, 12/10/2015 - 16:01 | 6906175 nopat
nopat's picture

Low interest rates boosting bank profitability?  Dude, NIM has been declining for the past 25 years.  Want to walk back from that statement you clearly pulled out of your ass?

This post is so self-contradictory it makes my head hurt...

Thu, 12/10/2015 - 16:02 | 6906191 kaboomnomic
kaboomnomic's picture

Before, i'm not certain when global depression starts. Looking at ZH data trends. I do know for certains, 2016 is the start. And 2017 it would get even worse.

Sometimes within those 2 years? World CB so desperates? They all would try GLOBAL CONCERTED "helicopter money". And that's way, i said 2017 would be worse.

Cause that helicopter money, wom't work..

Thu, 12/10/2015 - 16:07 | 6906233 maneco
maneco's picture

All Western central banks are in a bind. The Bank of England has left rates at near zero today for the 81st straight meeting!

https://youtu.be/c8pl8DdE2Ak

Thu, 12/10/2015 - 16:16 | 6906304 MadVladtheconquerer
MadVladtheconquerer's picture

The Devil went down to Georgia;

he was looking for a soul to steal;

he was in a bind;

cuz he was way behind; and he was willin' to make a deal:

https://www.youtube.com/watch?v=Fi13NxmjqLI

 

Thu, 12/10/2015 - 16:29 | 6906407 In.Sip.ient
In.Sip.ient's picture

"Despite talk of negative rates, the impetus lower interest rates give to expansion of the financial side of the economy has already come to an end"

 

The single most interesting line in the ENTIRE article!

Just think...

1) Holding rates steady...  wont' work.

2) Lowering rates...           won't work.

3) Raising rates...             won't work... and will

probably crash the entire financial sector...

 

When have you ever seen such a thorough

damned if you do and damned if you don't

situation???

 

 

 

 

Thu, 12/10/2015 - 16:59 | 6906592 MASTER OF UNIVERSE
MASTER OF UNIVERSE's picture

Answer: March 10th 2008, & September 14th 2008, that's when.

:|

Thu, 12/10/2015 - 23:23 | 6908349 T-NUTZ
T-NUTZ's picture

zugzwang

Thu, 12/10/2015 - 16:59 | 6906593 Vin
Vin's picture

Oh for G-d's sake, it's not "cluelessness", it's planned destruction!  Why can't you wrap your head around that??

Thu, 12/10/2015 - 20:31 | 6907487 Casey Jones
Casey Jones's picture

The clueless incompetent excuse is so tired. It worked famously for Bush Whitehouse after 9/11. I can't even count the number of times people told me, oh Bush is too stupid to pull that off. They shit their integrity down the toilet to make that work and it still works on many. Not that Bush isn't dumber than a bag of hammers, but the cunts who pull this shit are high IQ psychos who are on the other end of the incompetent scale.

Thu, 12/10/2015 - 20:27 | 6907464 Northern Flicker
Northern Flicker's picture

Obviously the banks don't pay enough to attracty talent.

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