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The Federal Reserve Triple Reverse Exit Strategy

The Fed Is Not Your Friend
The Automatic Earth
While it's true that the Federal Reserve didn't say it in so many words, that's only because it's not capable of saying anything at all in only so many words. Perhaps that's due to Greenspan's Oracle heritage. Still, between the lines the Fed did say it: it has given up on an imminent recovery of the American economy, and most of all, it has given up on the American people. (Caveat: to give up on something one must at one time have cared for it to begin with.)

The Fed's recent and persistent rosy predictions of a 4% or so economic growth for the US have become ridiculously untenable, and Bernanke et al wish that to be known. That can only mean one thing: they see a lot more trouble on the horizon, and wish to cover their behinds and reputations. In true Oracle fashion, the wording itself has changed from "moderate" growth in June to "more modest than anticipated" yesterday. Here's thinking that Bernanke's definition of "exceptionally low rates for an extended period" doesn't apply only to interest rates, it's equally valid for economic growth.

For many pundits, the only conclusion that can be drawn from this is that the Fed will "ease" more, and is preparing to use its "vast range" of monetary tools to fight the depression everyone still prefers to call a recession. But, assuming for a moment that the Fed has any intention of doing so, what then are these tools? Note that even as the wording of the expectations has gone sharply downward, all the board has said is that it will replace some $20 billion per month in maturing agency and mortgage backed securities with Treasuries, so it will not hold less than $2.05 trillion in such paper.

Does that help the economy at large? No, of course not. And this is where you can see that the Fed has given up on the American people. Actions such as these help the banks, and the banks only. That is what the Fed has adopted as its first and singular priority: to keep the bankrupt banking system propped up, and to such an extent that banks not only look healthy, they even get to dole out gigantic sums in bonuses. The $2.05 trillion "bottom" announced yesterday is there to make sure that the banks won't suffocate from the toxic fumes their very own "assets" are spreading.

And it could perhaps work, or, more correctly, might have worked. If only sufficient economic growth would have enabled the continuation of the scheme. Alas, even the imitation Oracles can't go any further, or do any better, than "more modest than anticipated". That threatens to bring down the foundations of all western governments' financial strategies, and America's most of all. All the times that Tim Geithner has declared that there was no need for a plan B, because a plan of his couldn't fail, strong economic growth was an indispensable element in the plans. Bernanke has now admitted that such growth will not be available. Count your blessings.

All the talk around yesterday's Fed announcement focuses on quantitative easing, QE2. Which is somewhat bewildering, given the utter failure of QE1 in the US. The only thing QE1 achieved, again, was to prop up banks. Yes, that succeeded. But the goal was, or so we were led to believe, that the trillions the Fed injected would percolate through to the real economy.

That didn't happen. And no, that is no surprise to the Fed. Remember, if you will, that Bernanke sometime last year announced that the Fed would from there on in pay banks interest on their excess reserves (reserves they're not legally required to hold). These reserves, which banks hold with the Fed, have gone from $1-2 billion a few years ago to over $1 trillion today. And the Fed pays interest over them. If ever you wonder if maybe the Fed and the Treasury aren't looking out for your best interests after all, you may want to wonder why Bernanke doesn't simply announce that those interest payments will be gone by tomorrow morning. That could make the banks lend out the money, couldn't it?

Well, not so fast. There are other things that are wrong with the entire quantitative easing concept that hardly anyone cares to look at. The Pragmatic Capitalist has a great explanation:
Quantitative Easing: "The Greatest Monetary Non-Event"
There is, perhaps, no greater misunderstanding in the investment world today than the topic of quantitative easing. After all, it sounds so fancy, strange and complex.  But in reality, it is quite a simple operation. JJ Lando, a bond trader at Goldman Sachs, has eloquently described QE:
“In QE, aside from its usual record keeping activities, the Fed converts overnight reserves into treasuries, forcing the private sector out of its savings and into cash. This is just a large-scale version of the coupon-passes it needed to do all along. Again, they force people out of treasuries and into cash and reserves.”
Some investors prefer to call it “money printing” or “stimulative monetary policy”.  Both are misleading and the latter is particularly misleading in the current market environment.  First of all, the Fed doesn’t actually “print” anything when it initiates its QE policy.  The Fed simply electronically swaps an asset with the private sector.  In most cases it swaps deposits with an interest bearing asset.  They’re not “printing money” or dropping money from helicopters as many economists and pundits would have you believe.  It is merely an asset swap.[..]

The most glaring example of failed QE is in Japan in 2001. Richard Koo refers to this event as the "greatest monetary non-event".  In his book, The Holy Grail of Macroeconomics, Koo confirms what the BIS states above:

"In reality, however, borrowers - not lenders, as argued by academic economists - were the primary bottleneck in Japan’s Great Recession.  If there were many willing borrowers and few able lenders, the Bank of Japan, as the ultimate supplier of funds, would indeed have to do something.  Butwhen there are no borrowers the bank is powerless."[..]
No, no - Mr. Bernanke hasn’t failed.  He just hasn’t tried hard enough….But perhaps the reader believes Japan is different and not applicable.  This is a reasonable objection.  So why don’t we look at the evidence from the last round of QE here in the USA.  Since Ben Bernanke initiated his great monetarist gaffe in 2008 there has been almost no sign of a sustainable private sector recovery. 

Mr. Bernanke’s new form of trickle down economics has surely fixed the banking sector (or at least bought some time), but the recovery ended there.  It did not spread to Main Street.  We would not even be having this discussion if we were in the midst of a private sector recovery. [..]

What is equally interesting (in addition to the fact that QE is not economically stimulative) with regards to this whole debate is that this policy response in time of a balance sheet recession is not actually inflationary at all.  With the government merely swapping assets they are not actually "printing" any new money.  In fact, the government is now essentially stealing interest bearing assets from the private sector and replacing them with deposits. 

This might have made some sense when the credit markets were frozen and bank balance sheets were thought to be largely insolvent, but now that the banks are flush with excess reserves this policy response would in fact be deflationary- not inflationary.  Why would we remove interest bearing assets from the private sector and replace them with deposits when history clearly shows that this will not stimulate borrowing?

So, there's no printing, and it's therefore not inflationary. Most of all, this is because nothing reaches the real economy. Bernanke's interest payments on excess reserves guarantee this outcome. What money banks do engage outside the Fed's vaults, they use for gambling on derivatives etc. Goldman made over a third of its profits last year from derivatives. And if these activities go awry, there's always the excess reserves to tap into. Get some at 0% (or close) at the discount window and get back to the gaming table. The 2010 US financial system in a nutshell.

Still, the key sentence above when it comes to the real economy is from Richard Koo: ... when there are no borrowers the bank is powerless .... This -crucial- statement appears again this morning in a piece from Rex Nutting at Marketwatch:
Monetary policy in a time of deleveraging
Who cares what it costs to borrow when no one wants to take out a loan?[..]

The Fed has [..] flooded the economy with hundreds of billions of dollars. Instead of putting it to work, the banks have taken the Fed's money and parked it. [..]

... no one wants to borrow, and that's the biggest problem in getting the economy moving again.

The economy needs money to grow, and money is created by borrowing. No borrowing, no money growth. No money growth, no economic growth. No economic growth, no jobs.

Even 0% loans aren't attractive when you're deleveraging, when you're trying to work off the hangover that inevitably follows a binge of borrowing.

"And there isn't a damn thing Chairman Bernanke and company can do about it,"says economist Stephen Stanley of Pierpont Securities.

Not a bad analysis, though of course it's simply not true that "The Fed has flooded the economy with hundreds of billions of dollars". . The Fed has flooded the banking system with all that money, but the banking system is not the same as the economy, even if the Geithners and Bernankes of this world would like you to think so, and are quite successful in convincing most people of this.

The take away from Nutting's piece is, even though we think we already know it, that money in our societies is created when people borrow it. It's then that a bank can create, for instance in the case of a mortgage, $250,000 with a keystroke. That's how we literally "make money". The Fed can do what it will, but if you're not going out there to get that loan, no money is created that actually enters the economy. No matter how many trillions the Fed hands over to Wall Street, it won’t go anywhere until you apply for a loan. Which, in today's circumstances, will then mostly be denied. Isn't the irony spectacularly appealing?

Craig Torres and Vivien Lou Chen at Bloomberg have a few more observations from the same Stephen Stanley Rex Nutting quotes in the article above, as well as a bit more on Bernanke's Oracle style:
Fed Reverses Exit Plans, Sets $2 Trillion Floor for Holdings
"There is absolutely zero evidence that if you let the balance sheet run down $10 billion to $15 billion a month that it would be a binding restraint on the economy," said Stephen Stanley, chief economist at Pierpont Securities [..]

"They have given us no evidence why quantitative easing works," Stanley said.

Some observers said yesterday’s decision took them by surprise after Bernanke and other officials in recent weeks maintained their outlook for a pickup in the economy over the next year. While weakness in housing and commercial real estate will restrain the recovery, and the job market’s "slow recovery" weighs on consumers, "rising demand from households and businesses should help sustain growth," Bernanke said in an Aug. 2 speech in Charleston, South Carolina.

"It seems like communications is a problem, particularly around turning points," said Timothy Duy, a University of Oregon economist who formerly worked at the U.S. Treasury Department. "It seems odd that 10 days ago you had a speech that hardly acknowledged the weakness of the recent data."

I think it should be obvious by now that that is exactly the kind of light in which to read yesterday's Fed announcement. Odd. But at the same time, it was quite the turnaround from all that's been said before, and right there lies the important bit. They've given up on the recovery, and to a much greater extent than they let on. Got to feed it to the people bite-size, that's politics for you. Makes you wonder how Obama and Geithner will spin it.

Don't forget that one of the policy requirements for the Federal Reserve is "maximum employment". And then look at what they're doing to achieve it. How will the president tell his people that no economic growth means no jobs?

One last thing: a huge chunk of the mortgage backed securities the Fed holds (some $1,25 trillion of them) originated with Fannie Mae and Freddie Mac. A "trick" very similar to the one that lets banks hold excess reserves at the Fed and get paid to do so, plays in the Fannie and Freddie universe. Where the Fed supposedly tries to support the economy through QE, but makes sure it can never work when it starts paying interest on reserves, the government makes sure the housing industry will not get back on its feet, simply by guaranteeing every single mortgage that's closed at inflated prices. Both "tricks" pretend to help the people, but both in the end only help to support a broke banking system. And it's impossible to keep up the illusion that none of these smart people have figured that one out.

Fannie Mae belongs to the government. Fannie Mae also has started advertising $1000 down mortgage loans in select parts of the US. Granted, it's a last stage of desperation move, but the fact that it's even considered is what tells us the story of how our "leaders" see the world around them. On the one hand, you’d be inclined to think that it's a good thing the phony facade is about to fall, but on the other you quickly realize who will be the victims once that happens.

And then you need to ask: what are those mortgage backed securities the Fed holds really worth, and who will eventually make up for the difference between face value and actual worth?

Look, mortgage rates are at record lows. And so are pending home sales. Combine those two, and you have all you need to know about the future of the American economy. It really is that simple.

If no-one's borrowing, the overall money supply goes down. That spells deflation, and the Fed is powerless against it. It can't force you to borrow. And if no economic growth materializes, you're not going to increase borrowing. Because you'll be losing your jobs, or famliy, friends, neighbors will, and you’ll be forewarned.

And they know it too, Bernanke and Geithner. The Fed doesn't support you, the American people, it supports the zombie banking system at your cost. Seen from that particular angle, by the way, it's doing a great job. I’ll leave it up to you to decide where the Treasury, and the US government in general, stand on this. Think Fannie and Freddie.