The Fed, a Senator, and a Grand Experiment

…as the dark forces of global Keynesianism exult at the prospect of yet another New Deal being launched somewhere in the world…it must be about time that one of them actually ‘did what it said on the tin’ and restored prosperity by means of a clod-hopping bout of fiscal monetary intervention to a people from whom it was taken by an earlier series of similarly ill-judged interventions from on high.
--Sean Corrigan

Unfortunately, the spectacular rise of Wall Street’s securitization machine will likely forever frustrate attempts to ascertain the extent to which the Fed is responsible for what happened to the U.S. housing market and financial system in 2008.  After all, it wouldn’t be fair to short sell (no pun intended) all the Special Purpose Vehicle sponsors, CDO asset managers, investors, and ratings agencies who, for at least five years, worked so hard to collapse the system. One wouldn’t want, for instance, to trivialize the type of sheer lunacy it takes to sell something like a “CDO squared” or its evil(er) cousin the “CDO cubed.” Similarly, it wouldn’t be appropriate to detract from the dazzling idiocy inherent in the idea that one subprime loan may be bad but a pool of them is “investment grade.” Just to drive the point home: one wouldn’t want to spend so much time analyzing the possible role of some silly little thing like the Fed funds rate that one forgets how much effort investors across the country expended clamoring after the always reliable mezzanine tranches of CDOs backed by pools of home equity loans.

Having thus given credit where it’s due we can say that while we may never be able to quantify the Fed’s role in creating the latest and most grand in what Marc Faber has aptly described as a string of bubbles, we can confidently say that the aggressive lowering of rates (from 6.5% in 2000 to just 1% in June 2003) was instrumental in creating the massive pool of securitizable mortgages that served as CDO fuel. The Fed thus facilitated the creation of untold amounts of faux household wealth and was so aloof it failed to see that aggressively raising rates from 2004 to 2006 would have the effect of shrinking the pool of borrowers just as Wall Street was perfecting its securitization technique. Ultimately, this resulted in the relaxation of lending standards, as originators competed for the remaining borrowers leading to a horrendous vintage of subprime loans in 2006. Meanwhile, the percentage of total mortgage securitizations comprised of subprime loans was hitting its peak.

Charts: Moody's

The Fed gaveth and it tooketh away or, as Sean Corrigan puts it, the FOMC’s “ill- judged interventions from on high” created unprecedented prosperity in the wake of the dot-com bubble and just as quickly facilitated the destruction of that prosperity.

As we enter 2013, the FOMC is busy inflating yet another asset bubble, this one far more spectacular than any that has come before. $2 trillion in asset purchases and counting has left the Fed’s balance sheet groaning under the weight of some 3 trillion in Treasuries and mortgage backed securities and not everyone is convinced the madness will end anytime soon. Goldman for instance, projects asset purchases lasting into 2015 and a Fed funds rate at zero until 2016, both more dovish predictions than the consensus:

This has of course ensured that the last leg of a three decade long bond market rally will indeed be the most spectacular and it is now truly difficult to fathom the scope of the dislocations the Fed’s exit will eventually cause.  And what, pray tell, has all of this done for the economy that just four years ago collapsed on itself partly as a result of these same Fed machinations? Virtually nothing; witness last quarter’s supposedly anomalous contraction-territory GDP print.

Rather than give up now, the Fed has instead used its own failed policies as an excuse to take even more unprecedented steps. The Fed is now targeting specific macroeconomic outcomes other than price stability and these targets will inform the timing of the cessation of unconventional policy. As Goldman has shown however, the Taylor rule shows that the Fed funds rate should be 3% by the time unemployment reaches 6.5% “given the committee’s inflation forecast.” The Fed it seems, no longer adheres to the pre-crisis Taylor Rule. From Goldman:

What accounts for this shift in behavior? One factor is clearly the increased weight on the employment side of the dual mandate. As shown in Exhibit 4, we estimate that the weight on the unemployment rate in our estimated Taylor rule with time-varying coefficients has increased sharply over the past two years. Once we allow for this increase, we can explain the steps taken by the FOMC to date.

Given this, it is worth recalling that on August 28 of last year, Tennessee Senator Bob Corker wrote a scathing op-ed in the Financial Times in which he dared to question the omnipotence of economic central planner in chief Ben Bernanke. Corker called the Chairman a “distraction” and urged the abolition of the dual mandate. On Monday, Corker took his criticism a step further and, along with Senator David Vitter, introduced the Federal Reserve Single Mandate Act. Corker says the Act will “provide the Fed with a clear and explicit focus on keeping inflation low [which] will serve America better than the broad, bipolar mandate it has today.” Corker also noted that “the dual mandate blurs the line between fiscal and monetary policy and allows Congress to shirk its responsibility to enact sound budgets and policies that produce economic growth.”

Politics aside, it is impossible to get around the fact that, contrary to the Chairman’s sworn testimony, the Fed is simply funding the U.S. deficit using the primary dealers as middlemen, although, given the collective ignorance of the general populace one seriously doubts whether the public would know the difference if the Fed just leap-frogged the secondary market and went straight to auction. In any case, perhaps Corker is naïve in a sense. Bernanke and his MIT cabal are busy conducting a grand experiment in monetary policy on a worldwide scale. Corker is no less the guinea pig than you or I, and no single bill will be enough to deter the central bankers of the Western world from taking their (possibly perverse) interpretation of Keynesianism to its logical extreme. All we mortals can do is sit back and hope the Gods aren’t as crazy as they seem.


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