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  • Why the Fed canít lower rates

    Why the Fed can’t lower rates

    Wondering why the Lehman failure and Monday's 500 point DOW drop didn’t move the Fed to cut on Tuesday? Short term, a cut won’t help. Long term, cuts shrink an already very short runway to zero interest rate hell.

    The effective Fed Funds rate shot up from 2.1% on Friday to 6% yesterday against a Fed Funds target rate of 2%. That’s because the Lehman bankruptcy left lenders to Lehman on the hook for hundreds of billions in losses. Now banks are afraid to lend to each other. We haven’t see that kind of dis-function since the crash of 1987.

    The Fed is thinking, Why use up ammo when the bond markets can’t do anything with it anyway? More importantly, targeting rates (the price of money) doesn't work at such times as these. We explained to subscribers in Zero Bound Diaries: Is Bernanke Volcker's Mirror Image? Feb. 12, 2008 ($ubscription), that the Fed is going to stop targeting rates and start to target aggregates after they drop rates to 2%, as it turned out two months later in April 2008. We can’t see the rise in M3 because the government doesn’t report M3 anymore -- clever.

    What it means is that the Fed has to risk moderate inflation now to try to avoid run-away inflation later. It's a big gamble that many countries throughout history have lost.

    Quantity versus the price of money

    The reason they are targeting aggregates is that as deflationary forces intensify with debt defaults, tightening lending standards, and a shrinking pool of credit-worthy borrowers, rate targeting (the price of money) becomes less effective as a policy tool to manage inflation. Targeting money aggregates (the quantity of money) becomes a more effective tool.

    It’s the flip side of the problem that the Fed had in the late 1970s when inflation was very high. The Fed switched to targeting quantity over price then, between 1979 to 1982, because money price targeting is ineffective at the extremes of high and low inflation.



    Instead of cutting rates, the Fed pumped in more cash.
    Fed pumps $70 billion into financial system to ease stresses as markets tumble
    Sept. 16, 2008 (AP)

    Urgently trying to keep cash flowing amid a Wall Street meltdown, the Federal Reserve on Tuesday pumped another $70 billion into the nation's financial system to help ease credit stresses.The Federal Reserve Bank of New York's action came in two operations in which $50 billion and then another regularly scheduled $20 billion were injected in temporary reserves

    The name of the game is to maintain the money supply as needed to keep inflation above zero percent because for a net debtor very ugly things happen at the zero bound.

    Not like this:


    Net creditor at the zero bound: Japan 1990 - 2005
    Currency strengthens, capital flows in, deflation dynamics set in

    ...or this:


    Net creditor at the zero bound: US 1927 - 1937
    Currency strengthens, capital flows in, deflation dynamics set in

    Net creditors like the US in the 1930s and Japan in the 1990s became recipients of global flight capital in a global financial and economic crisis; the currencies of net creditors appreciate relative to their trade partners’ as a result. As a percentage of GNP, the US is now a major net debtor. It is therefor vulnerable to the effects of a reversal in capital flows.

    Like this:

    Net debtor at the zero bound: Argentina 1995 - 2008
    Currency weakens, capital flees, inflation spikes

    ...and this:

    Net debtor at the zero bound: Russia 1995 - 2000
    Currency weakens, capital flees, inflation spikes

    Of course, the US has many advantages over both of these net debtor cases:
    • US foreign debt is denominated in US currency so it does not need to sell dollars to repay debt in another currency
    • Most of the debt is long term so it does not need to be rolled over
    • Foreign governments not private institutions now hold the majority of US debt so the foreign trade in US debt is less volatile but on the other hand more political (See China paper urges new currency order after "financial tsunami")
    • The US has a long history of political stability and come-backs from economic crisis so investors tend to believe that the US will quickly recover it s economic footing

    These factors will determine the result of the Ka-Poom disinflation-inflation process by degree but not the fundamental dynamic. The US has higher inflation and interest rates in its future. The questions are how high and when.

    Expectations drive markets short term, reality drives them long term

    Wait a minute, you say. Isn’t the dollar shooting up as money pours back into the US from emerging markets? Don’t forget the old adage, there’s nothing harder than emerging money from an emerging market during an emergency. Right?

    The US recovered from 2004 and 2006 because of growth driven by the housing bubble and foreign lending. Did you know 70% of the US fiscal – not trade – deficit was financed by foreign lending in 2003? True fact. What does a government do if it can't borrow the money? Three options: cut spending, thereby increasing unemployment, raise taxes, thereby cutitng demand, or print money, thereby wrecking the purchasing power of money – including tax revenues. That's how hyperinflations happen – the more the government prints to pay fixed expenses the more it has to print to pay fixed expenses.

    The US has been a safe haven for capital for decades. That changed with the terminal demise of the FIRE Economy starting in early 2007, but the global habit of thinking of the US the other way, as if it still were a safe haven, has not.

    Don’t be fooled by this bounce in the dollar. As soon as market participants realize that it cannot be sustained, it's curtains for 35 years of the borrow-and-spend FIRE Economy.

    Different this time for the US, same old same old for all net debtors in trouble throughout history

    In this global contraction, will Japan, China, Russia, Brazil et al be able to continue to finance America’s twin fiscal and trade deficits? Not if they are in recession, too, because – and this is key – demand from the US for their exports are falling off a cliff because the housing bubble demand engine died, an engine that directly via credit expansion and indirectly via purchases of consumer goods to fill houses, justified the foreign lending in the first place.

    Now unemployment is rising, credit and incomes are shrinking, and the future driver for the US economy in the wings that I am promoting – investment in transportation, energy, and communications infrastructure – has not yet gotten off the ground.

    The US is now like any other net debtor in an economic crisis without a way to grow its way out of debt.

    This time the US is in a position similar to Germany in 1930, Russia in the early 1990s or Argentina in the early 2000s, dependent on borrowing from countries that lost their ability to lend due to their own problems. Such countries become victims of global capital flight in a worldwide financial and economic crisis when a falling global economic tide lowers all ships.

    I know it’s hard to get your head around as an American because you love your country but it’s time for you to start to think of the US as at risk of capital flight versus a safe haven.

    How much faith do you have in the Fed?


    As we mentioned in Future inflation fears topple TIPS, by reducing exposure to inflation-index bonds the US government is not preparing for deflation.

    A once-in-a-century crash may occur if the Fed botches this and we get too close to the zero bound before the economy grows again. At this point in the race between the disinflationary impact of recession and debt deflation and the inflationary impact of moving all manner of worthless assets onto the Fed’s and Federal Government’s balance sheets, disinflation may be winning. At some point before the zero bound is reached, never mind the point of actual deflation (negative inflation rate such as -2%), if the US experience is like any other net debtor's in history a currency accident will occur as global financial markets realize that the US position as a safe haven relative to its trade partners has reversed. A rapid, self-reinforcing process of capital flight and dollar depreciation that we call “Poom” will begin.

    The Fed knows this. It is doing everything it can to keep inflation above zero and maintain dry powder, and that means keeping the Fed Funds rate target over 2%.


    Fed Funds effective rate spikes to 6% from 2.1% versus target rate of 2%
    the day of the Lehman bankruptcy


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    Last edited by FRED; 09-17-08, 06:32 PM.

  • #2
    Re: Why the Fed canít lower rates

    Originally posted by EJ View Post
    I know itís hard to get your head around as an American because you love your country but itís time for you to start to think of the US as at risk of capital flight versus a safe haven.

    How much faith do you have in the Fed?


    A once-in-a-century crash may occur if the Fed botches this and we get too close to the zero bound before the economy grows again. At this point in the race between the disinflationary impact of recession and debt deflation and the inflationary impact of moving all manner of worthless assets onto the Fedís and Federal Governmentís balance sheets, disinflation may be winning. At some point before the zero bound is reached, never mind the point of actual deflation (negative inflation rate such as -2%), if the US experience is like any other net debtor's in history a currency accident will occur as global financial markets realize that the US position as a safe haven relative to its trade partners has reversed. A rapid, self-reinforcing process of capital flight and dollar depreciation that we call ďPoomĒ will begin.

    The Fed knows this. It is doing everything it can to keep inflation above zero and maintain dry powder, and that means keeping the Fed Funds rate target over 2%.
    EJ,

    Thanks for another great article.

    What would the major asset classes likely do in the "Poom" you mentioned above? My understanding is that metals and other hard assets would soar in nominal terms. Industrial commodities would likely decline in real terms due to the decrease in demand, but could move up in nominal terms depending on the slope of the Poom. Similar story for stocks? Bonds? Forex?

    I'm beginning to wonder why I have so much cash in short term US paper, but maybe there's no hiding from this storm.

    Jimmy

    Comment


    • #3
      Re: Why the Fed canít lower rates

      "Funds effective rate spikes to 6% "

      In fact, here in the UK it went all the way to 6.7% but I am particularly reminded of past times where the UK economy was constantly shoved one way or the other by the government changing the aggregates. In the 1960,s we kept grinding to a halt when the money supply was constrained too much. So the lesson is that no government has a claim to being able to form policy in such a way as to not overreact to events.

      As this shows, the Fed has the right idea, (to control aggregates), but not by adding to the circulation, but instead, by very careful and not too rapid reductions. But I for one will not hold my breath that they get it right, they simply do not have the necessary track record.

      Hologram Tam & the Great Global Banking Money Supply Swindle
      http://www.marketoracle.co.uk/Article2365.html

      No, hardly news to iTulip, but it does add to the debate.

      Comment


      • #4
        Re: Why the Fed canít lower rates

        I'm beginning to wonder why I have so much cash in short term US paper, but maybe there's no hiding from this storm.

        Jimmy

        I'm beginning to wonder why I have so much in Precious metals and metal stocks instead of short term US paper. My portfolio is decimated, what a dumbass I am! Oh well, maybe I will look good wearing a barrel?

        Comment


        • #5
          Re: Why the Fed canít lower rates

          this evening on bloomberg radio there was an interview with brian sack, co-author with ben bernanke and vincent reinhart of "Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment." sack stated that when/if they lower from 2% they should do it in BIG steps - that the speed of the cuts could compensate for their relatively small room to maneuver.

          Comment


          • #6
            Re: Why the Fed canít lower rates

            Originally posted by jk View Post
            this evening on bloomberg radio there was an interview with brian sack, co-author with ben bernanke and vincent reinhart of "Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment." sack stated that when/if they lower from 2% they should do it in BIG steps - that the speed of the cuts could compensate for their relatively small room to maneuver.
            Bernanke Reasserts Dominance Over Wall Street

            Federal Reserve Chairman Ben Bernanke has reasserted his dominance as by far the most market-moving Fed official, a study released Tuesday showed, after having ceded some of the spotlight to regional Fed presidents in his first year as chairman.
            Bernanke
            According to Macroeconomic Advisers, Bernanke’s speeches in 2007 and 2008 accounted for over 0.60 percentage point of movements in the two-year Treasury yield, which is sensitive to monetary-policy expectations. That’s five times the market effect of the second-most influential official over the last 18 months, Fed Vice Chairman Donald Kohn.
            “It may be that the markets looked increasingly to the “heavyweights” on the FOMC to deliver the policy message, discounting the comments from other FOMC members,” Macroeconomic Advisers’ Laurence Meyer, who is a former Fed governor, and Brian Sack, a former Fed economist, wrote.


            so what's brian doing these days? on bloomberg shilling Macroeconomic Advisers services?

            any accountability for his opinions?

            "i think ben ought to jump off a cliff or lose control of his direction".

            Comment


            • #7
              Re: Why the Fed canít lower rates

              This is a great article complementing the Ka-Poom theory nicely. It is sinking in everyday. Thank you EJ.

              The question is: are we living through Ka and if so, how can someone identify a bottom in Ka to prepare for Poom?

              I am curious as to the duration of Ka in Russia and Argentina and its meaning for the US Ka-Poom. Seems very short for Argentina and somewhat longer for Russia.

              Comment


              • #8
                Re: Why the Fed canít lower rates

                A fabulous and interesting article revealing things I did not know.

                And perhaps inappropriate for an ideological discussion, but I will take immediate issue with this:

                What does a government do if it can't borrow the money? Three options: cut spending, thereby increasing unemployment [bolding added], raise taxes, thereby cutitng demand, or print money, thereby wrecking the purchasing power of money – including tax revenues.
                The bolded section is complete nonsense EJ. If you are talking about Keynsian beliefs, then sure. But if you are talking about the truth, I believe that this is an untruth. If the government cut taxes and cut spending, that would let workers, say, keep a higher percentage of their pay. It would make American workers more competitive and outsourcing less competitive.

                No end of good would come from cutting spending and certainly, unemployment would FALL. The government is the ultimate parasitic consumer, and it consumes money that otherwise would be used by productive entrepreneurs.

                Comment


                • #9
                  Re: Why the Fed canít lower rates

                  As somebody noted this is like the movie Weekend at Bernie's.

                  I get the feeling the Fed is working from a list starting at the top of the food chain and working down, first salvaging what can be had of the big boys and clearing the decks for the banks.

                  This seems to be moving alot faster than I thought it would, after reading about the Great Depression which was a kind of a slow moving drip, drip. I wonder if this event is going to be different, perhaps faster now that the world is wired for internet cell, etc. Communications with everybody in instant communication.

                  In 1930 your average citizen might get some detail in his home town paper after a couple of days. Now we get the news in min. with pretty good analysis from multiple sources sometimes in a hour or a few hours after the event via ITULIP and other sources. Sitting at my keyboard I can almost feel the shockwaves at my fingertips:eek:

                  So if there is a time compression here will the fed be ahead of events or running behind?

                  Comment


                  • #10
                    Re: Why the Fed canít lower rates

                    GJ what you say is true but I think you have a time lag problem. The immediate result of cutting spending and govt employment would be higher unemployment. It would take a while for the economy to reorganise itself efficiently to take up the slack.
                    That's why none of this can be painless and all the damned stupid deceiptful sociopath politicians with their lies, and downright ignorance, pretending that it can be, are just doing untold damage

                    Comment


                    • #11
                      Re: Why the Fed canít lower rates

                      Originally posted by The Outback Oracle View Post
                      GJ what you say is true but I think you have a time lag problem. The immediate result of cutting spending and govt employment would be higher unemployment. It would take a while for the economy to reorganise itself efficiently to take up the slack.
                      That's why none of this can be painless and all the damned stupid deceiptful sociopath politicians with their lies, and downright ignorance, pretending that it can be, are just doing untold damage
                      You could be right about a time lag. You could be right about everything you say here. But I still think one of the best things to come out of the coming conflagration could be a fall in the absolute belief in the power of government and a rise of liberty and independence. But then I am also deluded in my other views too...

                      Comment


                      • #12
                        Re: Why the Fed canít lower rates

                        Do you mean like this 'aggregates' like this chart ???
                        M1_Watch.jpg

                        Comment


                        • #13
                          Re: Why the Fed canít lower rates

                          Originally posted by EJ View Post
                          How much faith do you have in the Fed?

                          As we mentioned in Future inflation fears topple TIPS, by reducing exposure to inflation-index bonds the US government is not preparing for deflation.

                          A once-in-a-century crash may occur if the Fed botches this and we get too close to the zero bound before the economy grows again. At this point in the race between the disinflationary impact of recession and debt deflation and the inflationary impact of moving all manner of worthless assets onto the Fedís and Federal Governmentís balance sheets, disinflation may be winning. At some point before the zero bound is reached, never mind the point of actual deflation (negative inflation rate such as -2%), if the US experience is like any other net debtor's in history a currency accident will occur as global financial markets realize that the US position as a safe haven relative to its trade partners has reversed. A rapid, self-reinforcing process of capital flight and dollar depreciation that we call ďPoomĒ will begin.

                          The Fed knows this. It is doing everything it can to keep inflation above zero and maintain dry powder, and that means keeping the Fed Funds rate target over 2%.
                          In my lights, this question and EJ's answer expose the central weakness of the argument. Itulip believes that the Fed will be able to execute its chosen strategy--money from helicopters. This means that the Fed CANNOT botch the timing of its moves as it approaches the zero bound. Additionally, it assumes that there will be a currency event before the zero bound is breached.

                          How much faith do we have in the Fed? From the looks of it, we better have a good deal, for the rapidity of recent events--Fannie, Freddie, Lehman, AIG, Merrill--suggests that the escape window for the Fed may be very small indeed.

                          In no way do I mean to downplay the value of the insights and analysis here, but it is important for me to understand as clearly as possible the hinge on which the inflationary/deflationary issue swings.

                          For Ka-Poom to follow, we expect that the Fed will be sharply attentive, have perceptive foresight, and act decisively.

                          Comment


                          • #14
                            Re: Why the Fed canít lower rates

                            This is my first post here at iTulip so first I want to thank you all for this great resource: I have been learning a lot following your discussions, thanks!

                            After being enlightened by EJs post, I was wondering what are the different options to counter such net-debtor scenario in terms of protecting ones savings in dollars? Sure, get out of the dollar but where to and how?

                            I am particularly concerned about two components here: the US government and the health of financial institutions. I am thinking "currency controls, market closures, rigged asset and derivative pricing, bank shutdowns, the suspension of brokerage functions, the freezing of financial accounts".

                            Is the best one can do move money outside the US and then look for an appropriate investment?

                            Comment


                            • #15
                              Re: Why the Fed canít lower rates

                              So where is the chart showing what happens to a net debtor nation at the zero bound when that nation is the world's only super power and when that nation's currency is also the world's reserve currency?

                              Comment

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