The pressure is on the Federal Reserve


The popular mindset of Wall Street and investors has been defined in The Wall Street Journal Article for Friday (August 12), “The story of market inflation fights the Fed.” (the underlining is mine)

“The story of the spike in inflation that propelled investors into risky assets this summer was given a big boost by Wednesday’s numbers showing prices [inflation] down slightly last month.

Unfortunately, there is no sign that the Federal Reserve will change its mind and agree with investors that rates should fall further next year.

“Unfortunately” and “agree with investors” reveal the mood. It is the consequence of a prolonged environment of anomaly who has become a comfortable companion. Thus, any change is viewed with nervous skepticism – uncertainty tainted with fear of the unknown.

Anomaly? Oh good?

Yes. The proof can be found by looking back to October 2009. The stock market was well above its March 2009 Great Recession low, anticipating the economic rebound that was taking shape then. Either way, Ben Bernanke was stuck on his very abnormal 0% return policy initiated in 2008.

This policy was determined solely by the few members of the Federal Reserve’s Open Market Committee. They had usurped the interest rate setting role of the capital markets, believing that they could generate better results than the normal market process based on the demand and supply of capital.

The abnormality is that the “seekers” (users of capital) were delighted with the bargain price. As President Trump once said of infrastructure funding (I’m paraphrasing), “it’s an obvious move, because the funding is free.”

The problems started quickly. Instead of borrowing for wise capital investment, excess production has been created leading to gluts of supply and hence abnormal price declines. Remember the worries about deflation?

Then came the Great Disappointment. Instead of a boost in economic growth and employment, there has been heavy borrowing for the payment of dividends, stock buybacks and simply enlargements of cash reserves. As a result, earnings per share and stock prices rose well, making equity investors and Wall Street happy with the Fed’s actions.

During those halcyon days, ill-rewarded providers of capital were ignored. Normally, the lowest rate for short-term, risk-free securities (think 3-month US Treasuries) was the rate of inflation. It meant at least one real interest rate (corrected for inflation) of 0%. During the years on the 0% of the Fed nominal interest rate (not adjusted for inflation), these capital providers received a negative real rate – typically around -1.5% to -2%. By making real rates worse over the first ten years, all those trillions of dollars in short-term assets lost about 20% of their purchasing power. How’s that for a hit of inflation? Now think about what they’re losing right now… Despite the Fed raising rates (the US 3-month treasury is now at 2.6%) inflation has risen faster, which has boosted yield real negative. Without Fed control, the minimum rate for 3-month US Treasuries would likely be 5% to 6%.

The following chart shows the 60+ year relationship between the 3-month US Treasury yield and the 12-month inflation rate (CPI minus food and energy). Note Alan Greenspan’s two experiments with a long post-recession 0% real interest rates (adjusted for inflation). It followed those with a slow climb back to capital market determined rates. The long Bernanke-initiated nominal The 0% interest rate period has not yet returned to normal.

Why not read up on these issues?

On the cover of the October 19, 2009 issue, Barrons announced its lead article in large bold print: “Come on, Ben. give them a break. The “them” meant all savers, investors, organizations, companies, funds and state/local governments that were required or wished to hold short-term and/or safe financial instruments. (The underlining is mine)

“IT’S TIME FOR THE FEDERAL RESERVE TO STOP talking about an ‘exit’ strategy and start implementing one.

There is no need for short-term rates to stay close to zero now that the economy is recovering. The call to action is clear: gold, oil and other commodities are up, the dollar is down and the stock market is booming. The move of the Dow Jones Industrial Average above 10,000 last week underlines the renewed health of the markets. Extremely low short rates fuel financial speculation, irritate our economic partners and foreign creditors and potentially fuel inflation.

The Fed does not seem to distinguish between normal accommodative monetary policy and accommodative policy in the event of a crisis. There is a huge difference.

With the crisis clearly over, the Fed is expected to raise short-term rates to a more normal 2% – still low by historical standards – to send a signal to markets that the United States is serious about supporting its beleaguered currency and that the worst is over for the global economy. Years of low short rates helped create the housing bubble, and the Fed risks fostering another financial bubble with its current policies.

Then there is this precise description of the harm done, which the Fed has always been silent about:

It is also time for the Fed to examine the plight of the nation’s savers, who are now earning sub-1% returns on money market funds and are being forced to take on substantial interest rate or credit risk. ‘they want higher returns. “The Fed punishes the cautious people and rewards the profligate people,” a seasoned investor told Barron’s. Many unemployed and underemployed Americans may deserve mortgage relief, but there are also millions of Americans – mostly seniors – who have saved diligently and now have little income to show for a lifetime of effort.”

Finally, a reminder of what the beneficiaries of the low rates were doing…

“Speculators, meanwhile, borrowed in dollars to buy a range of financial assets because of near-zero borrowing costs and the prospect of repaying those loans with a depreciating currency.”

Conclusion: We are in a historic era that will have repercussions for years to come

These 13-year-old problems described by Barrons are neither outdated nor out of place. As has happened after all previous economic and financial periods, full explanations and analyzes will emerge at the end of this Ben Bernanke experiment, that is, when capital markets regain control. The comparisons and contrasts will highlight the anomalous effects, disparities and inequalities created since 2008.

Hopefully that day will come soon as the continuation of abnormally low interest rates carries high risk now that the inflation warning light is on.

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