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The All Powerful Federal Reserve: Part II

Posted by Larry Doyle on June 12, 2009 12:19 PM |

Is the All Powerful Federal Reserve omniscient, omnipotent, and omnipresent? Any institution that purports to be transparent but ultimately clouds itself in a shroud of “financial intrigue” deserves serious questioning. Congressional efforts on this front regularly fall woefully short. With a few exceptions, serious media analysis of the Fed is also deficient. Fortunately, the Wall Street Journal provides a reasonable overview of recent Fed maneuvers, Fed to Keep Lid on Bond Buys. Let’s navigate the inner workings of the Fed and play devil’s advocate in the process.

The WSJ highlights:

Fed officials have become more confident recently that they have stabilized the economy and set the stage for recovery. But divisions are brewing within the Fed over whether it should do more to speed the healing, pause, or start pulling back to avoid an outbreak of inflation.

Those crosscurrents are likely to inhibit bold new strokes by the Fed at its next meeting, in contrast to earlier in the year, when a bleak outlook spurred aggressive action.

At long last, a hint of sanity on the inflation front emanates from within the hallowed halls of the kingdom of the Federal Reserve.

Please recall that when the Fed announced its increased level of aggressive quantitative easing, the 10 yr Treasury rallied 50 basis points from a 3.1% to a 2.6% in one day. That sort of move is unprecedented. The 10yr, even with the Fed’s support, has since retraced 1.2% in the last three months. Where would the 10yr Treasury be without Fed support? 4%, 4.25%, 4.5%? Who could estimate for sure?

The fact is the Fed may have injected too much liquidity too fast into the system. What are the results of the “liquidity rush?” Markets which are disconnected with the underlying economic fundamentals. Fed officials seem to appreciate that they may have overplayed their hand. The WSJ offers color on this front:

Interest rates on everything from business loans to home mortgages tend to move in tandem with Treasury rates. If government-bond rates rise too much too fast, they could short-circuit a recovery by choking off consumer and business borrowing and spending.

Fed officials aren’t convinced that is happening yet, so they aren’t inclined to use their muscle to restrain bond yields any more than they have already set out to do. That could change if their views of markets and the economy change. Fed officials say much needs to be hashed out at the next meeting.

Do you get the feeling that these Fed officials are operating much like NASA controllers? Too much speed, and our “economic” airbus may very well overshoot the runway. Too much fuel and we may burn up prior to reentry. If that is the case, we may need to “dump” some fuel prior to reentry. How does the All Powerful Fed manage this delicate and technical task? Very carefully. To wit, the WSJ offers:

When officials convene on June 23 and 24 in Washington, one idea on the table will be to stretch out over a longer period of time planned purchases of Treasury securities or mortgage-backed securities. Doing so would avoid an abrupt, and perhaps disruptive, end to the buying and give the Fed time to assess the outlook. The Treasury has set out to buy $300 billion of Treasurys by the end of August. It is on a path to buy $1.25 trillion of mortgage-backed securities by the end of this year or early next year.

So far, the Fed has purchased $156.5 billion of government bonds. Officials could also change the mix of their purchases.

The Fed has utilized approximately half its “purchasing powder” and rates have backed up a staggering 1-1.25% in the process. Why? Inflationary fears. Do we run the risk of further fueling the engines of inflation by pumping even more money into the tank? I believe we do and fortunately some within the Fed are starting to appreciate the signals being sent by the market.

Some Fed officials worry that if they wait too long to reverse the tidal wave of money they’ve pumped into the financial system, that could spark inflation — a threat that bond markets might already be signaling by pushing up Treasury yields. “Just as there is slack, there is also an enormous amount of stimulus in the economy and coming into the economy,” said Kansas City Fed President Thomas Hoenig in an interview. “Being too slow to remove our expansionary actions would very likely be inflationary.”

Is the All Powerful Fed capable of properly pushing and pulling the economic levers at its disposal?

The Fed’s task is complicated by the fact that it is using tools it has never used before.

Here’s hoping this flight does not also include, “Houston, we’ve got a problem.”

LD

  • fiscalliberal

    Let us hope they are using tools they have never used before as they completely screwed up the system with what they did. Part of this was the Greenspan ideology not to use tools and Paulson’s sensitivity to moral hazard. Some how transparency has to be one dominant tool.

    Interesting perspective on Squawk Box this morning from one of the guests commenting about inflation. He was not worried because we are simply in undercapacity utilization of production. Hence as soon as there is a demand, production will be available and the resources are not necessarily scarce, keeping prices reasonable.

    I wonder if the inflation is driven by liquidity and scarce resources. I.E. you need both.

    For certain the Economists are in a new area and the tools are new. However from Krugmans book, the some of the theory has been applied in other countries with mixed results.

    Hopefully our kids learn from this.

  • I saw that interview as well. I think the point that analyst and others is missing is that for the level of demand in our economy, we may not necessarily have as much slack capacity as he or they think.

    As such inflation can pick up much more easily.

    In regard to learning, the issue I see here is the massive violations of moral hazards. We may think we are learning but those lessons may yet to be truly learned.

    Time will tell…

  • Wanting to know

    Hi Larry. I dropped by to ask what’s up with the mortgage rates but got my answer in your thread.

    rates have backed up a staggering 1-1.25% in the process. Why? Inflationary fears

    The next question is where do you think this is headed?
    Will rates continue to climb? This sudden hike in rates has stalled the Real Estate purchasing and refi market even though rates are still not that bad yet. I mean the low 5% rate and under was really stimulating the economy but that’s all come to a premature and abrupt end and during peak selling and refi season.
    What’s on your radar with this?
    I noticed that a gallon of gas has risen more than a dollar since Jan 20th, 2009.
    Food prices are as bad or worse than they were this past Fall. Has inflation begun? If so, people will stop spending again, so where does that leave the market?
    I have a hunch this may have been manipulated due to the enormous amounts of Mortgage loans being processed, so much so, that they are backed up for 1 month turn time and taking up to 60 days or more to complete the loan.
    They want to slow the housing market down for now to get a breather and like you said to assess the situation? FHA loans written in the past few months are off the charts. Is this absurd or could there be a sliver of truth to this hunch of mine?

    • Wanting….glad you came to Sense on Cents and were able to find your answer to your initial question.

      In regard to your second question: whether the government would like to slow the housing market down . . .

      I would ask, who is “they”? If they is Uncle Sam, then the answer is categorically “NO!!” In fact, Uncle Sam has done, is doing, and will continue to do anything they can to support housing. What are they doing? The Federal Reserve’s massive purchases of mortgages via the mortgage-backed securities market, the mortgage modification programs, and forestalling foreclosures.

      If “they” are private investors, then you are headed in the right direction with your intuition. Private investors view the massive flows of liquidity into our economy (please read my post from the other day, “What’s Driving the Market”) along with the equally massive borrowing needs by Uncle Sam and are shying away from buying bonds. Why?

      1. inflation….too much money chasing too few goods….

      2. Uncle Sam’s demand for credit (borrowing) will be approximately 4 times greater in 2009 than prior years. Some of that borrowing is to support programs initiated by Bush and plenty of it is to fund the massive budget and government initiatives proposed by Obama.

      So I do not think the government wants to temper the economy or merely housing. The group tempering the situation is collectively known as “bond vigilantes,” that is, bond investors in general.

      Standard operating procedures of a market trying to pretend it is adhering to rules of “free market capitalism.”

      Hope this makes “sense.” Please visit and comment often!!

    • Wanting…I overlooked answering your question about rates. Yes, I do think rates will continue to climb. Why?

      Two reasons, which I touched upon in my previous answer:

      1. Massive refinancing needs by global government needs, corporations, municipalities, individuals. (Not all of these groups will gain access to credit).

      2. Inflation and equally as important the fear of inflation. Remember, the greatest component of inflation is the mere expectation of inflation. In my opinion, we are developing those expectations currently.






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