Fed Watch Thread

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Did Doubling Reserve Requirements Cause the Recession of 1937-1938?

research.stlouisfed.org/wp/2011/2011-002.pdf

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The Fed Is Gifting Primary Dealers With A Monthly Commission Fee Of Over $5 Billion
Submitted by Tyler Durden on 01/12/2011

POMO


The topic of how much money the Fed is gifting to the Primary Dealers via POMO commissions has to become front and center right now. While we appreciate fluff "profile" pieces in the NYT addressing the issue tangentially, and assuring us via worthless promises by people whose one purpose in life is to pad the pockets of their future employers in preparation for that inevitable day when said parasites move from faux public service to doing the hard core biddings of a vampire squid, the truth is that this is daylight robbery and it is happening in front of everyone's eyes. As a reminder, per the NYT: "As offers to sell Treasuries flash on a bank of trading screens, a computer algorithm works out which ones to accept." We contest that this algorithm is costing tapxayer billions each and every month and demand that Bill Dudley, Brian Sack, Josh Frost or one of the 20 year old henchmen traders immediately disclose just what the operatinal terms of the algorithm are, and what the slippage is. The reason: we have reason to believe that the Fed's slippage rate is up to 5%. On a monthly POMO notional total of over $100 billion, this means that the Fed hands out well over $5 billion each and every month to the Primary Dealers. This is an abortion of the Fed's fiduciary responsibility and should be criminal if proven to be in fact correct.

John Lohman explains:

If the Fed’s POMO desk had one single Bloomberg, they could compare their weighted average accepted prices with each cusip’s 10:59 price (one minute before the POMO closing) as a means of determining the efficiency of their “computer algorithm”.

A sampling of about 30 issues from the latest report confirms an average of 5% slippage. This means the most recent month of POMOs gifted $5 billion in commissions directly to the PDs. If they won’t drop the charade and go directly to auction (where the $5 billion would at least be gifted indirectly to the taxpayer via lower auction yields), they should consider signing up for TradeWeb and buy anonymously like the rest of us. And send their “computer algorithm” back to Moody’s.

Surely there is one Congressman or woman who is not so bloody stupid, and actually understand that this is nothing short of legal and mandated theft from taxpayers, with the money being handed out directly to the Primary Dealers.

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See example posts & articles from opponents:

Virtually All Independent Financial Experts Say that the Size of the Big Banks Is Hurting the Economy
Submitted by George Washington on 01/12/2011 14:44 -0500

Bank of EnglandDean BakerFederal Deposit Insurance CorporationFederal ReserveFederal Reserve BankFisherGreat DepressionInternational Monetary FundMilton FriedmanNourielRichard FisherRobert ReichSheila BairSimon JohnsonTARP


→ Washington’s Blog

Here's my updated list of top financial experts saying that the giant banks are too big, and that their very size is hurting the economy:

•Nobel prize-winning economist, Joseph Stiglitz
•Nobel prize-winning economist, Ed Prescott
•Former chairman of the Federal Reserve, Alan Greenspan
•Former chairman of the Federal Reserve, Paul Volcker
•Former Secretary of Labor Robert Reich
•Dean and professor of finance and economics at Columbia Business School, and chairman of the Council of Economic Advisers under President George W. Bush, R. Glenn Hubbard
•Former chief IMF economist and economics professor Simon Johnson (and see this)
•President of the Federal Reserve Bank of Kansas City, Thomas Hoenig (and see this)
•President of the Federal Reserve Bank of Dallas, Richard Fisher (and see this)
•President of the Federal Reserve Bank of St. Louis, Thomas Bullard
•Deputy Treasury Secretary, Neal S. Wolin
•The President of the Independent Community Bankers of America, a Washington-based trade group with about 5,000 members, Camden R. Fine
•The Congressional panel overseeing the bailout (and see this)
•The head of the FDIC, Sheila Bair
•Former Tarp overseer and creator of the Consumer Financial Protection Bureau, Elizabeth Warren
•The head of the Bank of England, Mervyn King
•The leading monetary economist and co-author with Milton Friedman of the leading treatise on the Great Depression, Anna Schwartz
•Economics professor and creator of the "efficient market hypothesis", Eugene Fama
•Economics professor and senior regulator during the S & L crisis, William K. Black
•Economics professor, Nouriel Roubini
•Economics professor, James Galbraith
•Economist, Marc Faber
•Professor of entrepreneurship and finance at the Chicago Booth School of Business, Luigi Zingales
•Economics professor, Thomas F. Cooley
•Economist Dean Baker
•Economist Arnold Kling
•Former investment banker, Philip Augar
•Chairman of the Commons Treasury, John McFall
•Leading bank analyst, Chris Whalen

To see why these experts say the giant banks need to be broken up, see the explanation here, after the list.

www.zerohedge.com/article/virtually-all-independent-financial-experts-say-size-big-banks-hurting-economy

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www.washingtonsblog.com/2010/12/economy-cannot-recover-until-big-banks.html

Why do these experts say the giant banks need to be broken up?


Well, small banks have been lending much more than the big boys. The giant banks which received taxpayer bailouts have been harming the economy by slashing lending, giving higher bonuses, and operating at higher costs than banks which didn't get bailed out.

As Fortune pointed out, the only reason that smaller banks haven't been able to expand and thrive is that the too-big-to-fails have decreased competition:

Growth for the nation's smaller banks represents a reversal of trends from the last twenty years, when the biggest banks got much bigger and many of the smallest players were gobbled up or driven under...

As big banks struggle to find a way forward and rising loan losses threaten to punish poorly run banks of all sizes, smaller but well capitalized institutions have a long-awaited chance to expand.



Read more at: www.huffingtonpost.com/2009/05/11/justice-department-plans-_n_201409.htmlSo the very size of the giants squashes competition, and prevents the small and medium size banks to start lending to Main Street again.

And as I noted in December 2008, the big banks are the major reason why sovereign debt has become a crisis:
The Bank for International Settlements (BIS) is often called the "central banks' central bank", as it coordinates transactions between central banks.

BIS points out in a new report that the bank rescue packages have transferred significant risks onto government balance sheets, which is reflected in the corresponding widening of sovereign credit default swaps:


The scope and magnitude of the bank rescue packages also meant that significant risks had been transferred onto government balance sheets. This was particularly apparent in the market for CDS referencing sovereigns involved either in large individual bank rescues or in broad-based support packages for the financial sector, including the United States. While such CDS were thinly traded prior to the announced rescue packages, spreads widened suddenly on increased demand for credit protection, while corresponding financial sector spreads tightened.
In other words, by assuming huge portions of the risk from banks trading in toxic derivatives, and by spending trillions that they don't have, central banks have put their countries at risk from default.
A study of 124 banking crises by the International Monetary Fund found that propping banks which are only pretending to be solvent hurts the economy:


Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.

Cross-country analysis to date also shows that accommodative policy measures (such as substantial liquidity support, explicit government guarantee on financial institutions’ liabilities and forbearance from prudential regulations) tend to be fiscally costly and that these particular policies do not necessarily accelerate the speed of economic recovery.


***

All too often, central banks privilege stability over cost in the heat of the containment phase: if so, they may too liberally extend loans to an illiquid bank which is almost certain to prove insolvent anyway. Also, closure of a nonviable bank is often delayed for too long, even when there are clear signs of insolvency (Lindgren, 2003). Since bank closures face many obstacles, there is a tendency to rely instead on blanket government guarantees which, if the government’s fiscal and political position makes them credible, can work albeit at the cost of placing the burden on the budget, typically squeezing future provision of needed public services.
Now, Greece, Portugal, Spain and many other European countries - as well as the U.S. and Japan - are facing serious debt crises. We are no longer wealthy enough to keep bailing out the bloated banks. See this, this, this, this, this and this.

Indeed, the top independent experts say that the biggest banks are insolvent (see this, for example), as they have been many times before. By failing to break up the giant banks, the government will keep taking emergency measures (see this and this) to try to cover up their insolvency. But those measures drain the life blood out of the real economy.

And by failing to break them up, the government is guaranteeing that they will take crazily risky bets again and again, and the government will wrack up more and more debt bailing them out in the future. (Anyone who thinks that Congress will use the current financial regulation - Dodd-Frank - to break up banks in the middle of an even bigger crisis is dreaming. If the giant banks aren't broken up now - when they are threatening to take down the world economy - they won't be broken up next time they become insolvent either. And see this. In other words, there is no better time than today to break them up).

Moreover, Richard Alford - former New York Fed economist, trading floor economist and strategist - recently showed that banks that get too big benefit from "information asymmetry" which disrupts the free market.
Indeed, Nobel prize-winning economist Joseph Stiglitz noted in September that giants like Goldman are using their size to manipulate the market:

"The main problem that Goldman raises is a question of size: 'too big to fail.' In some markets, they have a significant fraction of trades. Why is that important? They trade both on their proprietary desk and on behalf of customers. When you do that and you have a significant fraction of all trades, you have a lot of information."

Further, he says, "That raises the potential of conflicts of interest, problems of front-running, using that inside information for your proprietary desk. And that's why the Volcker report came out and said that we need to restrict the kinds of activity that these large institutions have. If you're going to trade on behalf of others, if you're going to be a commercial bank, you can't engage in certain kinds of risk-taking behavior."
The giants (especially Goldman Sachs) have also used high-frequency program trading which not only distorts the markets - making up more than 70% of stock trades - but which also lets the program trading giants take a sneak peak at what the real (that is, human) traders are buying and selling, and then trade on the insider information. See this, this, this, this and this. (This is frontrunning, which is illegal; but it is a lot bigger than garden variety frontrunning, because the program traders are not only trading based on inside knowledge of what their own clients are doing, they are also trading based on knowledge of what all other traders are doing). Goldman also admitted that its proprietary trading program can "manipulate the markets in unfair ways".


Moreover, JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley together hold 80% of the country's derivatives risk, and 96% of the exposure to credit derivatives. Experts say that derivatives will never be reined in until the mega-banks are broken up - and see this - even though the lack of transparency in derivatives is one of the main risks to the economy.

The giant banks have also allegedly used their Counterparty Risk Management Policy Group (CRMPG) to exchange secret information and formulate coordinated mutually beneficial actions, all with the government's blessings.

Again, size matters. If a bunch of small banks did this, manipulation by numerous small players would tend to cancel each other out. But with a handful of giants doing it, it can manipulate the entire economy in ways which are not good for the American citizen.

In addition, as everyone from Paul Krugman to Simon Johnson has noted, the banks are so big and politically powerful that they have bought the politicians and captured the regulators. So their very size is preventing the changes needed to fix the economy.

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Published: May 11, 2009
WASHINGTON — President Obama’s top antitrust official this week plans to restore an aggressive enforcement policy against corporations that use their market dominance to elbow out competitors or to keep them from gaining market share.

Susan Etheridge for The New York Times
Christine Varney, left, of the Justice Department’s antitrust division.
The new enforcement policy would reverse the Bush administration’s approach, which strongly favored defendants against antitrust claims. It would restore a policy that led to the landmark antitrust lawsuits against Microsoft and Intel in the 1990s.

The head of the Justice Department’s antitrust division, Christine A. Varney, is to announce the policy reversal in a speech she will give on Monday before the Center for American Progress, a liberal policy research organization. She will deliver the same speech on Tuesday to the United States Chamber of Commerce.

The speeches were described by people who have consulted with her about the policy shift. The administration is hoping to encourage smaller companies in an array of industries to bring their complaints to the Justice Department about potentially improper business practices by their larger rivals. Some of the biggest antitrust cases were initiated by complaints taken to the Justice Department.

Ms. Varney is expected to say that the administration rejects the impulse to go easy on antitrust enforcement during weak economic times.

She will assert instead that severe recessions can provide dangerous incentives for large and dominating companies to engage in predatory behavior that harms consumers and weakens competition. The announcement is aimed at making sure that no court or party to a lawsuit can cite the Bush administration policy as the government’s official view in any pending cases.

In the speeches, Ms. Varney is expected to explicitly warn judges and litigants in antitrust lawsuits not involving the government to ignore the Bush administration’s policies, which were formally outlined in a report by the Justice Department last year. The report applied legal standards that made it difficult to bring new cases involving monopoly and predatory practices.

As a result of the Bush administration’s interpretation of antitrust laws, the enforcement pipeline for major monopoly cases — which can take years for prosecutors to develop — is thin. During the Bush administration, the Justice Department did not file a single case against a dominant firm for violating the antimonopoly law.

Many smaller companies complaining of abusive practices by their larger rivals were so frustrated by the Bush administration’s antitrust policy that they went to the European Commission and to Asian authorities.

Ms. Varney’s new policy more closely aligns American antitrust policy on monopolies and predatory practices with the views of antitrust regulators at the European Commission.

Herbert Hovenkamp, a leading antitrust scholar regarded as a centrist between those seeking more aggressive enforcement and those who generally argue for restraint, said the guidelines by the Bush administration were “a brief for defendants.”

He said that the repudiation of those guidelines by the Obama administration “will almost certainly have a greater impact than the guidelines themselves had.”

“This will be bad news for heavyweights in the tech industries — companies like Google and Microsoft,” said Professor Hovenkamp, who teaches at the University of Iowa College of Law.

“People aligned with plaintiffs will rejoice. Those aligned with defendants will wring their hands. A lot of law firms will be indifferent because they take money from both sides.”

Ms. Varney is expected to say that the Obama administration will be guided by the view that it was a major mistake during the outset of the Great Depression to relax antitrust enforcement, only to try to catch up and become more vigorous later. She will say the mistake enabled many large companies to engage in pricing, wage and collusive practices that harmed consumers and took years to reverse.

While Ms. Varney is not expected to mention any specific companies or industries vulnerable under the new policy, those who have talked to her about the speech say she is aiming at agriculture, energy, health care, technology and telecommunications companies. She may also be reviewing the conduct of some in the financial services industry, which is now undergoing a wave of consolidation as a result of the financial crisis.

Ms. Varney, who headed the Internet practice group of the Washington-based Hogan & Hartson law firm, served as a commissioner at the Federal Trade Commission in the 1990s after working in the White House during the early years of the Clinton administration.

Signaling her intent to revive a moribund antitrust program, she has recruited a collection of senior aides, many of whom are seasoned antitrust litigators or worked in the Clinton administration and the Federal Trade Commission and were involved in many prominent cases, including the one against Microsoft. They include Molly S. Boast, William Cavanaugh, Gene Kimmelman, Carl Shapiro and Philip J. Weiser.

Antitrust policy is set by Washington in two ways: by the interpretation of laws announced by the Justice Department and the Federal Trade Commission through guidelines for the courts and private litigants, and by the enforcement cases that those agencies decide to bring. The government’s guidelines are often cited by lawyers and given considerable weight by judges in antitrust cases, including those lawsuits that the government does not participate in.

It is not unlawful for a company to gain control of a market. It becomes unlawful if the company engages in conduct to exclude or harm competitors with no business justification.

Conservative antitrust experts, some judges and defendants in such cases have said that the line is too difficult to draw and that it is better to let rivalries play out in the marketplace than in the courts.

After more than a year of hearings and studies, the Justice Department in 2008 published a 215-page report analyzing Section 2 of the Sherman Antitrust Act, explaining the government’s approach to the monopolistic and predatory practices of companies.

Reflecting deep skepticism of the role of government in the marketplace, the 2008 report made formal a set of policies that had largely been followed by the Justice Department, but not by the Federal Trade Commission, during the Bush administration.

When the report was issued, Thomas Barnett, then the head of the antitrust division and the architect of the guidelines, said that they were meant to articulate “clear standards” for determining whether certain types of conduct by large companies would harm competition.

In a rare split with the Justice Department, three of the four commissioners at the Federal Trade Commission denounced the guidelines, calling them “a blueprint for radically weakened enforcement” against anticompetitive practices

====================


WAY OVER DUE. That's exactly how legislation combats stagflation.

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Fed Releases New POMO Schedule, To Monetize $112 Billion In Bonds And Prop Up Stocks On 18 Out Of 19 Trading Days
Submitted by Tyler Durden on 01/12/2011 14:07 -0500

Agency MBSPOMO


The New York Fed's equity crash prevention team of Sack-Frost has just released its most recent POMO schedule. Over the next month, ending on February 9, the Fed will purchase about $112 billion in debt in 18 discrete operations. And for the first time unlike the prior two QE2 monthly schedules, there is not one dual POMO day. From the release: "Across all operations in the schedule listed below, the Desk plans to purchase approximately $112 billion. This represents $80 billion in purchases of the announced $600 billion purchase program and $32 billion in purchases associated with principal payments from agency debt and agency MBS expected to be received between mid-January and mid-February." The days when there is no POMO will be Monday, January 17 and Wednesday, January 26. All other days have a POMO operation scheduled.

===============


The POMO purchases are linear. Monetary lags are fixed in length. An inflection point (collision), is coming where you sell SHORT both bonds & stocks.

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Alicia Damley Seeking Alpha


Recognizing the pro-cyclicality of BIS II rules, the Basel Committee identified counter-cyclical provisions as one of the key changes in the proposed BIS III standards. At the end of December 2010, global regulators from 27 countries agreed on implementing counter-cyclical provisions through increases in the minimum Tier 1 capital ratio by up to 2.5% (from 7% to 9.5%).

Furthermore, one country’s regulator, having identified the development of a bubble and requiring its banks to hold more capital, will result in regulators in other countries requiring their banks to hold proportionally higher capital. For example, Country A’s regulator identifying a bubble would require all banks operating in the country, regardless of domicile, to hold more capital for the portion of the business in Country A. This coordinated response should contribute to a more level playing field amongst banking peers.

Conceptually and practically, this marks significant change. First, the introduction of counter-cyclical provisions marks the reintroduction of a type of general provision for loan losses. This category of provisions was eliminated as accounting standards broadly shifted towards eliminating smoothing type-line items in financial statements. Consequently, a company’s balance sheet and earnings statements more closely reflected the underlying economic activity in the business with the trade-off of increased volatility in some of the figures. General provisions had provided banks with an additional loss absorption cushion, explicitly recognizing the estimation error in realized loan losses.

Rapid loan growth in a specific loan category (e.g. mortgages, credit cards, SME, etc.) is regularly accompanied by higher loan losses following a gestation period. This simple rule holds true regardless of geography, loan category or size of bank. While estimating the length of the gestation period is not always easy, the pattern of loss cyclicality is clearly evident. Counter-cyclical provisioning explicitly recognizes this pattern. Furthermore, it enables banks to build provisions when there is the capacity to do so (i.e. during times of higher earnings), thereby adding to and protecting capital. Protecting capital in a leveraged institution is invaluable, particularly on the way down.

Another important effect of counter-cyclical provisions is the potential dampening effect on the same excess growth associated with bubble formation. Higher growth, which accelerates the formation of counter-cyclical provision, consumes a larger portion of earnings, reducing internally generated surplus capital available to fund new growth. In another negative feedback loop, lending growth inevitably adds downward pressure on lending margins as more banks seek to take part and increase share in a fast-growing lending segment. Witness the downward pressure on mortgage margins in the U.K., Ireland, Spain -- and even France and Italy -- in the run-up to the global financial crisis.

In the U.K., teaser rate mortgages saw mortgage margins drop to below 40 bps. Declining lending margins leads to lower revenue, if not sufficiently offset by higher lending volume. Furthermore, adding to provisions reduces earnings and the corresponding return on assets and equity. This can contribute to slowing the growth accompanied by a decline in lending margins, as bank flexibility to sustain them is reduced.

Operationally, the Bank of Spain’s approach to the creation of counter-cyclical provisions, introduced in 2000, provides the likely template. Both addition to and consumption of this provision is determined by formula. Applying run-rate estimates for the average credit loss across a cycle, plus a loan segment specific loss, form the basis for provision build-up. If sufficient history and data are available, the calculation can be tailored to the bank’s own loss development history and reflect its credit risk competence and capability.

This would have a self-reinforcing effect on the bank’s incentive to maintain strong credit risk capabilities and related functions. Consistent evidence supporting this should be persuasive to the market in differentiated valuation. Identifying the start of excess credit growth is likely to be one of the implementation challenges, but quarterly reviews of loan growth compared to historical trends could facilitate consensus.

[Click to enlarge]



Source: Analistas Financieros Internacionales presentation

Limited use of this mechanism to date means there is currently limited empirical data on the effect of counter-cyclical provisions. While these provisions are unlikely to outright eliminate recessions or even structural problems within a financial system, they can at least moderate a tendency towards runaway credit growth and dampen the corresponding loss impact on a bank’s earnings from rapidly rising loan defaults. The Bank of Spain’s implementation of counter-cyclical provisions has provided its banking system with at least 14 months of respite from rapidly developing non-performing loan losses and expense.

Given the banking system’s propensity for lending losses, requirements for earlier and higher provision development, and a more orderly workout from ill-advised lending is beneficial. This would also provide a bank and its regulator with some flexibility in its inevitable capital-raising needs. Overall, as banks continue to see increasing downward pressure on returns, rising lending margins are an inevitable outcome of the latest global financial crisis.

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Record Fed Profits Paid To Treasury
By Bob McTeer on January 12, 2011|

The Board of Governors recently announced a record $78.4 billion of Reserve bank earnings paid to the Treasury (and taxpayers) in 2010, up from a record $47.4 billion in 2009. These record earnings come from the growth in assets related to recent Fed policy. To the extent that outstanding Treasury debt is purchased by the Fed, the burden of interest payments on the public debt is reduced almost proportionally.

As usual, serial Fed bashers are stretching to find ways to criticize the Fed. This time, the criticism is directed at the fiscal windfall which is a by-product of its monetary policy. One such basher, a former Fed official who should know better, said on Cable TV that the Fed was broke or near broke because a rise in interest rates could easily wipe out the Fed’s capital if its assets were marked to market, which should be done in his opinion.

First, there is no need for the Fed to mark to market since its assets are not held for trading and can easily be held to maturity or recovery if necessary. Second, the Fed’s liabilities are mainly the required reserves of the banking system not subjecting to withdrawal except as banking assets shrink. Fed liabilities are not hot money. Third, the Fed’s capital is required to be held by member banks and is subject to calls that would double its size if necessary. In other words, the Federal Reserve and other central banks are unique institutions and the usual rules and ratios don’t apply.

Regular banks, to some degree, still “borrow short and lend long.” They are vulnerable to losing deposits and faster than they can liquidate assets; so their capital is at risk. The deposit liabilities of Federal Reserve Banks, however, are the reserve deposits that banks are required to maintain at the Fed as a percentage of their own deposit liabilities. The excess reserve component has risen in the past two years, but mostly they are required reserves. The Fed’s ability now to pay interest on reserves, including excess reserves, gives it a tool, if needed, to incent even excess reserves to remain. In other words, those who hold the Fed’s liabilities are compelled to do so.

The Fed’s capital account is also unique. When banks become members of the Federal Reserve System, which is mandatory for national banks and voluntary for state banks, they have to purchase stock in their local Federal Reserve Bank equal to six percent of their own capital and surplus. Three percent of that is paid in to the Fed and the other three percent is subject to call by the Fed. In other words, if needed, the Fed could double its capital level simply by calling the second half.

In summary, central banks are unique and aren’t subject to the same liquidity crises as private banks. The expansion of Fed assets could become overdone and stoke inflation. It will certainly create a tricky exit situation when the time comes. In the meantime, one result of it’s asset expansion is fiscal relief for the Treasury and the taxpayer. Let’s not look a gift horse in the mouth.

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Securities Holdings as of January 12, 2011
($ thousands)

Summary T-Bills T-Notes & T-Bonds TIPS Agencies


Security Type Total Par Value
US Treasury Bills (T -Bills).......................................... 18,422,636.7
US Treasury Notes and Bonds (Notes/Bonds).......... 987,625,063.7
Treasury Inflation-Protected Securities (TIPS)........149,742,567.2
Federal Agency Securities2....................................... 146,331,000.0
Mortgage-Backed Securities3 (Settled Holdings).... 992,141,090.8
Total SOMA Holdings.............................................. 2,194,262,358.4
Change From Prior Week............................................... 29,942,000.0

====

"On August 10, 2010, the Federal Open Market Committee directed the Open Market Trading Desk (the Desk) at the Federal Reserve Bank of New York to keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities (agency MBS) in longer-term Treasury securities. The most recent H.4.1 data release indicates that outright holdings of domestic securities in the System Open Market Account (SOMA) totaled $2.054 trillion as of August 4, 2010"

SOMA is NOW UP $140b since the start of the first reinvestment of principal & interest announcement (@ 2,054T)

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DAILY AVG IN MILLIONS
Two weeks ended % CHANGE IN WEEKLY AVERAGES
Dec/29/2010 Dec/15/2010…………………………………. 13-wk…26-wk…52-wk

Total reserves…$1,060,974…$1,097,067……….……….17.4.…..-3.2……...0.9

Non-borrowed reserves…1,015.632…1,051,375..…..20.4…….1.0.……14.4

Required reserves…69,778… 72,219……………………....-6.0…..11.7….…...8.2

Excess reserves…991.195… 1,024,848………………...…19.1..….-4.1….……0.5

Borrowings from Fed…45,342…45,689………………….-42.6.…-66.7……-73.0

Free reserves…945,853…979,159………………………..…22.4……..0.3……..14.9

======

Required reserves have reversed course & turned negative (a sell signal for commodities).

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ELLEN BROWN:

The Federal Reserve was set up by bankers for bankers, and it has served them well. Out of the blue, it came up with $12.3 trillion in nearly interest-free credit to bail the banks out of a credit crunch they created. That same credit crisis has plunged state and local governments into insolvency, but the Fed has now delivered its ultimatum: there will be no “quantitative easing” for municipal governments.

On January 7, according to the Wall Street Journal, Federal Reserve Chairman Ben Bernanke announced that the Fed had ruled out a central bank bailout of state and local governments. “We have no expectation or intention to get involved in state and local finance,” he said in testimony before the Senate Budget Committee. The states “should not expect loans from the Fed.”

So much for the proposal of President Barack Obama, reported in Reuters a year ago, to have the Fed buy municipal bonds to cut the heavy borrowing costs of cash-strapped cities and states.

The credit woes of state and municipal governments are a direct result of Wall Street’s malfeasance. Their borrowing costs first shot up in 2008, when the “monoline” bond insurers lost their own credit ratings after gambling in derivatives. The Fed’s low-interest facilities could have been used to restore local government credit, just as it was used to restore the credit of the banks. But Chairman Bernanke has now vetoed that plan.

Why? It can hardly be argued that the Fed doesn’t have the money. The collective budget deficit of the states for 2011 is projected at $140 billion, a mere drop in the bucket compared to the sums the Fed managed to come up with to bail out the banks. According to data recently released, the central bank provided roughly $3.3 trillion in liquidity and $9 trillion in short-term loans and other financial arrangements to banks, multinational corporations, and foreign financial institutions following the credit crisis of 2008.

The argument may be that continuing the Fed’s controversial “quantitative easing” program (easing credit conditions by creating money with accounting entries) will drive the economy into hyperinflation. But creating $12.3 trillion for the banks — nearly ten times the sum needed by state governments — did not have that dire effect. Rather, the money supply is shrinking – by some estimates, at the fastest rate since the Great Depression. Creating another $140 billion would hardly affect the money supply at all.

Why didn’t the $12.3 trillion drive the economy into hyperinflation? Because, contrary to popular belief, when the Fed engages in “quantitative easing,” it is not simply printing money and giving it away. It is merely extending CREDIT, creating an overdraft on the account of the borrower to be paid back in due course. The Fed is simply replacing expensive credit from private banks (which also create the loan money on their books) with cheap credit from the central bank.

So why isn’t the Fed open to advancing this cheap credit to the states? According to Mr. Bernanke, its hands are tied. He says the Fed is limited by statute to buying municipal government debt with maturities of six months or less that is directly backed by tax or other assured revenue, a form of debt that makes up less than 2% of the overall muni market. Congress imposed that restriction, and only Congress can change it.

That may sound like he is passing the buck, but he is probably right. Bailing out state and local governments IS outside the Fed’s mandate. The Federal Reserve Act was drafted by bankers to create a banker’s bank that would serve their interests. No others need apply. The Federal Reserve is the bankers’ own private club, and its legal structure keeps all non-members out.

Earlier Central Bank Ventures Into Commercial Lending
That is how the Fed is structured today, but it hasn’t always been that way. In 1934, Section 13(b) was added to the Federal Reserve Act, authorizing the Fed to “make credit available for the purpose of supplying working capital to established industrial and commercial businesses.” This long-forgotten section was implemented and remained in effect for 24 years. In a 2002 article called “Lender of More Than Last Resort” posted on the Minneapolis Fed’s website,

David Fettig summarized its provisions as follows:

• [Federal] Reserve banks could make loans to any established businesses, including businesses begun that year (a change from earlier legislation that limited funds to more established enterprises).

• Reserve banks were permitted to participate [share in loans] with lending institutions, but only if the latter assumed 20 percent of the risk.

• No limitation was placed on the amount of a single loan.

• A Reserve bank could make a direct loan only to a business in its district.

Today, that venture into commercial banking sounds like a radical departure from the Fed’s given role; but at the time it evidently seemed like a reasonable alternative. Fettig notes that “the Fed was still less than 20 years old and many likely remembered the arguments put forth during the System’s founding, when some advocated that the discount window should be open to all comers, not just member banks.” In Australia and other countries, the central bank was then assuming commercial as well as central bank functions.

Section 13(b) was repealed in 1958, but one state has kept its memory alive. In North Dakota, the publicly owned Bank of North Dakota (BND) acts as a “mini-Fed” for the state. Like the Federal Reserve of the 1930s and 1940s, the BND makes loans to local businesses and participates in loans made by local banks.

The BND has helped North Dakota escape the credit crisis. In 2009, when other states were teetering on bankruptcy, North Dakota sported the largest surplus it had ever had. Other states, prompted by their own budget crises to explore alternatives, are now looking to North Dakota for inspiration.

The “Unusual and Exigent Circumstances” Exception
Although Section 13(b) was repealed, the Federal Reserve Act retained enough vestiges of it in 2008 to allow the Fed to intervene to save a variety of non-bank entities from bankruptcy. The problem was that the tool was applied selectively. The recipients were major corporate players, not local businesses or local governments. Fettig writes:

Section 13(b) may be a memory, . . . but Section 13 paragraph 3 . . . is alive and well in the Federal Reserve Act. . . . [T]his amendment allows, “in unusual and exigent circumstances,” a Reserve bank to advance credit to individuals, partnerships and corporations that are not depository institutions.

In 2008, the Fed bailed out investment company Bear Stearns and insurer AIG, neither of which was a bank. John Nichols reports in The Nation that Bear Stearns got almost $1 trillion in short-term loans, with interest rates as low as 0.5%. The Fed also made loans to other corporations, including GE (GE), McDonald’s (MCD), and Verizon (VZ).

In 2010, Section 13(3) was modified by the Dodd-Frank bill, which replaced the phrase “individuals, partnerships and corporations” with the vaguer phrase “any program or facility with broad-based eligibility.” As explained in the notes to the bill:

Only Broad-Based Facilities Permitted. Section 13(3) is modified to remove the authority to extend credit to specific individuals, partnerships and corporations. Instead, the Board may authorize credit under section 13(3) only under a program or facility with “broad-based eligibility.”

What programs have “broad-based eligibility” isn’t clear from a reading of the Section, but long-term municipal bonds are evidently excluded. Mr. Bernanke said that if municipal defaults became a problem, it would be in Congress’ hands, not his.

Congress could change the law, just as it did in 1934, 1958, and 2010. It could change the law to allow the Fed to help Main Street just as it helped Wall Street. But as Senator Dick Durbin blurted out on a radio program in April 2009, Congress is owned by the banks. Changes in the law today are more likely to go the other way. Mike Whitney, writing in December 2010, noted:

So far, not one CEO or CFO of a major investment bank or financial institution has been charged, arrested, prosecuted, or convicted in what amounts to the largest incident of securities fraud in history. In the much-smaller Savings and Loan investigation, more than 1,000 people were charged and convicted. . . . [T]he system is broken and the old rules no longer apply.

The old rules no longer apply because they have been changed to suit the moneyed interests that hold Congress and the Fed captive. The law has been changed not only to keep the guilty out of jail but to preserve their exorbitant profits and bonuses at the expense of their victims.

To do this, the Federal Reserve had to take “extraordinary measures.” They were extraordinary but not illegal, because the Fed’s congressional mandate made them legal. Nobody’s permission even had to be sought. Section 13(3) of the Federal Reserve Act allows it to do what it needs to do in “unusual and exigent circumstances” to save its constituents.

[flow5]

Time to SELL SHORT:

(1) GOLD
(2) CRB index
(3) CRUDE Oil

I.e., almost all commodities should be sold short now.

[flow5]

Government Says No to Helping States and Main Street, While Continuing to Throw Trillions at the Giant Banks

The Wall Street Journal noted last week:

Federal Reserve Chairman Ben Bernanke on Friday ruled out a central bank bailout of state and local governments strapped with big municipal debt burdens, saying the Fed had limited legal authority to help and little will to use that authority.


"We have no expectation or intention to get involved in state and local finance," Mr. Bernanke said in testimony before the Senate Budget Committee. The states, he said later, "should not expect loans from the Fed."

Congress has also discontinued the Build American Bond program, which was significant in temporarily financing California and other states' budgets. See this, this, this and this.


That's unfortunate, given that many states and big cities are in a dire financial situation, and given that Keynesian economists say that aid to the states is one of the best forms of stimulus.

In any event, as Steve Keen points out, giving money to the debtors is much better for stimulating the economy than giving it to the lenders.

Unfortunately, as I will demonstrate below, virtually the entire government economic policy is to throw trillions of dollars at the biggest banks.

Because there are so many rivers and streams of bailout money going to the big banks, I will start with the specifics and end with broader monetary policies.


Tarp: a Preview of Things to Come


The $700 billion dollar TARP bailout was a massive bait-and-switch. The government said it was doing it to soak up toxic assets, and then switched to saying it was needed to free up lending. It didn't do that either. Indeed, the Fed doesn't want the banks to lend.


As I wrote in March 2009:

The bailout money is just going to line the pockets of the wealthy, instead of helping to stabilize the economy or even the companies receiving the bailouts:

•Bailout money is being used to subsidize companies run by horrible business men, allowing the bankers to receive fat bonuses, to redecorate their offices, and to buy gold toilets and prostitutes
•A lot of the bailout money is going to the failing companies' shareholders
•Indeed, a leading progressive economist says that the true purpose of the bank rescue plans is "a massive redistribution of wealth to the bank shareholders and their top executives"
•The Treasury Department encouraged banks to use the bailout money to buy their competitors, and pushed through an amendment to the tax laws which rewards mergers in the banking industry (this has caused a lot of companies to bite off more than they can chew, destabilizing the acquiring companies)
And as the New York Times notes, "Tens of billions of [bailout] dollars have merely passed through A.I.G. to its derivatives trading partners".

***

In other words, through a little game-playing by the Fed, taxpayer money is going straight into the pockets of investors in AIG's credit default swaps and is not even really stabilizing AIG.
But the TARP bailout is peanuts compared to the numerous other bailouts the government has given to the giant banks.

And I'm not referring to the $23 trillion in bailouts, loans, guarantees and other publicy-disclosed programs that the special inspector general for the TARP program mentions. I'm talking about more covert types of bailouts.


Like what?

Mortgages and Housing

Most independent experts say that the government's housing programs have been a failure. That's too bad, given that the housing slump is now - according to Zillow's - worse than in the Great Depression.


Indeed, PhD economists John Hussman and Dean Baker, fund manager and financial writer Barry Ritholtz and New York Times' writer Gretchen Morgenson say that the only reason the government keeps giving billions to Fannie and Freddie is that it is really a huge, ongoing, back-door bailout of the big banks.

Many also accuse Obama's foreclosure relief programs as being backdoor bailouts for the banks. (See this, this, this and this).

Commercial Real Estate, Mortgage Backed Securities, Cars and Student Loans


Some pretty sharp writers allege that the government is also secretly bailing out the banks by supporting everything from commercial real estate, to mortgage-backed securities, car loans and student loans (and don't forget McDonald's and Harley).


Derivatives

The government's failure to rein in derivatives or break up the giant banks also constitute enormous subsidies, as it allows the giants to make huge sums by keeping the true price points of their derivatives secret. See this and this.

Foreign Bailouts

The big banks - such as JP Morgan - also benefit from foreign bailouts, such as the European bailout, as they are some of the largest creditors of the bailed out countries, and the bailouts allow them to get paid in full, instead of having to write down their foreign losses. So when the Fed bails out foreign banks, it is a bailout for American banks as well.

Toxic Assets and Accounting Shenanigans


The PPIP program - which was supposed to reduce the toxic assets held by banks - actually increased them (at least in the short-run), and just let the banks make a quick buck.

In addition, the government suspended mark-to-market valuation of the toxic assets held by the giant banks, and is allowing the banks to value the assets at whatever price they desire. This constitutes a huge giveaway to the big banks.

As Forbes' Robert Lenzner wrote recently:

The giant US banks have been bailed out again from huge potential writeoffs by loosey-goosey accounting accepted by the accounting profession and the regulators.

They are allowed to accrue interest on non-performing mortgages ” until the actual foreclosure takes place, which on average takes about 16 months.

All the phantom interest that is not actually collected is booked as income until the actual act of foreclosure. As a resullt, many bank financial statements actually look much better than they actually are. At foreclosure all the phantom income comes off the books of the banks.

This means that Bank of America, Citigroup, JP Morgan and Wells Fargo, among hundreds of other smaller institutions, can report interest due them, but not paid, on an estimated $1.4 trillion of face value mortgages on the 7 million homes that are in the process of being foreclosed.

Ultimately, these banks face a potential loss of $1 trillion on nonperforming loans, suggests Madeleine Schnapp, director of macro-economic research at Trim-Tabs, an economic consulting firm 24.5% owned by Goldman Sachs.

The potential writeoffs could be even larger should home prices continue to weaken...
And as one writer notes:

By allowing banks to legally disregard mark-to-market accounting rules, government allows banks to maintain investment grade ratings.

By maintaining investment grade ratings, banks attract institutional funds. That would be the insurance and pension funds money that is contributed by the citizen.

As institutional money pours in, the stock price is propped up ....

Fraud As a Business Model

If you stop and think for a moment, it is obvious that failing to prosecute fraud is a bailout.

Nobel prize-winning economist George Akerlof demonstrated that if big companies aren't held responsible for their actions, the government ends up bailing them out. So failure to prosecute directly leads to a bailout.


Moreover, as I noted last month:


Fraud benefits the wealthy more than the poor, because the big banks and big companies have the inside knowledge and the resources to leverage fraud into profits. Joseph Stiglitz noted in September that giants like Goldman are using their size to manipulate the market. The giants (especially Goldman Sachs) have also used high-frequency program trading (representing up to 70% of all stock trades) and high proportions of other trades as well). This not only distorts the markets, but which also lets the program trading giants take a sneak peak at what the real traders are buying and selling, and then trade on the insider information. See this, this, this, this and this.


Similarly, JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley together hold 80% of the country's derivatives risk, and 96% of the exposure to credit derivatives. They use their dominance to manipulate the market.

Fraud disproportionally benefits the big players (and helps them to become big in the first place), increasing inequality and warping the market.

[And] Professor Black says that fraud is a large part of the mechanism through which bubbles are blown.

***

Finally, failure to prosecute mortgage fraud is arguably worsening the housing crisis. See this and this.


The government has not only turned the other cheek, but aided and abetted the fraud. In the words of financial crime expert William K. Black, the government "created an intensely criminogenic environment".

And this environment is ongoing today. See this, for example.
Settling Prosecutions For Pennies on the Dollar


Even when the government has prosecuted financial crime (because public outrage became too big to ignore), the government has settled for pennies on the dollar.

Nobel prize winning economist Joe Stiglitz says about the way that the government is currently prosecuting financial crime:

The system is designed to actually encourage that kind of thing, even with the fines [referring to former Countrywide CEO Angelo Mozillo, who recently paid tens of millions of dollars in fines, a small fraction of what he actually earned, because he earned hundreds of millions.].

***

So the system is set so that even if you're caught, the penalty is just a small number relative to what you walk home with.

The fine is just a cost of doing business. It's like a parking fine. Sometimes you make a decision to park knowing that you might get a fine because going around the corner to the parking lot takes you too much time.

Bloomberg noted on Monday:

The U.S. Securities and Exchange Commission’s internal watchdog is reviewing an allegation that Robert Khuzami, the agency’s top enforcement official, gave preferential treatment to Citigroup Inc. executives in the agency’s $75 million settlement with the firm in July.

Inspector General H. David Kotz opened the probe after a request from U.S. Senator Charles Grassley, an Iowa Republican, who forwarded an unsigned letter making the allegation. Khuzami told his staff to soften claims against two executives after conferring with a lawyer representing the bank, according to the letter….

According to the letter, the SEC’s staff was prepared to file fraud claims against both individuals. Khuzami ordered his staff to drop the claims after holding a “secret conversation, without telling the staff, with a prominent defense lawyer who is a good friend” of his and “who was counsel for the company, not the individuals affected,” according to a copy of the letter reviewed by Bloomberg News.

And Freddie and Fannie's recent settlement with Bank of America - a couple of billions - has been criticized by many as being a bailout.


In "BofA Freddie Mac Putbacks Resolved for 1¢ on $", Barry Ritholtz notes:

Bank of America settled numerous claims with Fannie Mae for an astonishingly cheap rate, according to a Bloomberg report.

A premium of $1.28 billion was paid to Freddie Mac to resolve $1 billion in claims currently outstanding. But the kicker is that the deal also covers potential future claims on $127 billion in loans sold by Countrywide through 2008. That amounts to 1 cent on the dollar to Freddie Mac.

In "Is Fannie bailing out the banks?", Forbes' Colin Barr writes:

Someone must be getting bailed out, right?

Why yes, say critics of the giant banks. They charge that Monday's rally-stoking mortgage-putback deal between Bank of America (BAC) and Fannie Mae and Freddie Mac is nothing more than a backdoor bailout of the nation's largest lender. It comes courtesy, they say, of an administration struggling to find a fix for the housing market while quaking at the prospect of another housing-fueled banking meltdown.

Monday's arrangement, according to this view, will keep the banks standing -- but leave taxpayers on the hook for an even bigger tab should a weak economic recovery falter. Sound familiar?

***

[Edward] Pinto says truly holding BofA responsible for all the mortgage mayhem tied to its 2008 purchase of subprime lender Countrywide would likely drive it into the arms of the Federal Deposit Insurance Corp., which has enough problems to deal with. Though BofA would surely dispute that analysis, it's easy enough to see where the feds don't want that outcome.

***

But how sharp is Freddie if all it can do is squeeze a $1.28 billion payment out of a giant customer in exchange for relinquishing fraud claims on $117 billion worth of outstanding loans? The very best its million-dollar executives can do is claw back a penny on each bubbly subprime dollar?

That seems pretty weak even given that this is Congress' favorite subsidy dispenser we're talking about.

"How Freddie can justify this decision to settle 'all outstanding and potential' claims before any of the private-label putback lawsuits have been resolved is beyond comprehension," says Rebel Cole, a real estate and finance professor at DePaul University in Chicago. "This smells to high heaven and they should be called out."
In "Bank Of America Just Admitted That Its Fannie And Freddie Settlement Was A Bailout", Business Insider's Joe Weisenthal writes:

Bank of America has basically confirmed that the critics are correct: It was the beneficiary of a bailout.
According to Bloomberg, BofA's Jerry Dubrowski said: “Our agreements with Fannie Mae and Freddie Mac are a necessary step toward the ultimate recovery of the housing market.”

Get it? This was not about settling mortgage putback exposure at the legal level. It was about helping the greater good. It's the same too-big-to-fail logic all over again: What's good for Bank of America is good for America.

As the Washington post notes:


“This is a gift” from the government to the bank, said Christopher Whalen of Institutional Risk Analytics. “We’re all paying for this because it will show up in the losses from Fannie and Freddie,” he said.
Congresswoman Waters said:

I’m concerned that the settlement between Fannie Mae, Freddie Mac and Bank of America over misrepresentations in the mortgages BofA originated may amount to a backdoor bailout that props up the bank at the expense of taxpayers. Given the strong repurchase rights built into Fannie Mae and Freddie Mac’s contracts with banks, and the recent court setback for Bank of America in similar litigation with a private insurer, I’m fearful that this settlement may have been both premature and a giveaway. The fact that Bank of America’s stock surged after this deal was announced only serves to fuel my suspicion that this settlement was merely a slap on the wrist that sets a bad example for other negotiations in the future.


And see this, this and this.

Guaranteeing a Fat Spread on Interest Rates


Bloomberg notes:

“The trading profits of the Street is just another way of measuring the subsidy the Fed is giving to the banks,” said Christopher Whalen, managing director of Torrance, California-based Institutional Risk Analytics. “It’s a transfer from savers to banks.” The trading results, which helped the banks report higher quarterly profit than analysts estimated even as unemployment stagnated at a 27-year high, came with a big assist from the Federal Reserve. The U.S. central bank helped lenders by holding short-term borrowing costs near zero, giving them a chance to profit by carrying even 10-year government notes that yielded an average of 3.70 percent last quarter.

The gap between short-term interest rates, such as what banks may pay to borrow in interbank markets or on savings accounts, and longer-term rates, known as the yield curve, has been at record levels. The difference between yields on 2- and 10-year Treasuries yesterday touched 2.71 percentage points, near the all-time high of 2.94 percentage points set Feb. 18.

Harry Blodget explains:


The latest quarterly reports from the big Wall Street banks revealed a startling fact: None of the big four banks had a single day in the quarter in which they lost money trading.

For the 63 straight trading days in Q1, in other words, Goldman Sachs (GS), JP Morgan (JPM), Bank of America (BAC), and Citigroup (C) made money trading for their own accounts.

Trading, of course, is supposed to be a risky business: You win some, you lose some. That's how traders justify their gargantuan bonuses--their jobs are so risky that they deserve to be paid millions for protecting their firms' precious capital. (Of course, the only thing that happens if traders fail to protect that capital is that taxpayers bail out the bank and the traders are paid huge "retention" bonuses to prevent them from leaving to trade somewhere else, but that's a different story).

But these days, trading isn't risky at all. In fact, it's safer than walking down the street.

Why?

Because the US government is lending money to the big banks at near-zero interest rates. And the banks are then turning around and lending that money back to the US government at 3%-4% interest rates, making 3%+ on the spread. What's more, the banks are leveraging this trade, borrowing at least $10 for every $1 of equity capital they have, to increase the size of their bets. Which means the banks can turn relatively small amounts of equity into huge profits--by borrowing from the taxpayer and then lending back to the taxpayer.

***

The government's zero-interest-rate policy, in other words, is the biggest Wall Street subsidy yet. So far, it has done little to increase the supply of credit in the real economy. But it has hosed responsible people who lived within their means and are now earning next-to-nothing on their savings. It has also allowed the big Wall Street banks to print money to offset all the dumb bets that brought the financial system to the brink of collapse two years ago. And it has fattened Wall Street bonus pools to record levels again.

Paul Abrams chimes in:


To get a clear picture of what is going on here, ignore the intermediate steps (borrowing money from the fed, investing in Treasuries), as they are riskless, and it immediately becomes clear that this is merely a direct payment from the Fed to the banking executives...for nothing. No nifty new tech product has been created. No illness has been treated. No teacher has figured out how to get a third-grader to understand fractions. No singer's voice has entertained a packed stadium. No batter has hit a walk-off double. No "risk"has even been "managed", the current mantra for what big banks do that is so goddamned important that it is doing "god's work".

Nor has any credit been extended to allow the real value-producers to meet payroll, to reserve a stadium, to purchase capital equipment, to hire employees. Nothing.

Congress should put an immediate halt to this practice. Banks should have to show that the money they are borrowing from the Fed is to provide credit to businesses, or consumers, or homeowners. Not a penny should be allowed to be used to purchase Treasuries. Otherwise, the Fed window should be slammed shut on their manicured fingers.

And, stiff criminal penalties should be enacted for those banks that mislead the Fed about the destination of the money they are borrowing. Bernie Madoff needs company.

Interest Paid on Excess Reserves


The Fed has been paying the big banks interest on the "excess reserves" which those banks deposit at the Fed.

Specifically, the Fed is intentionally paying the banks a higher interest rate to park their money at the Fed than they would make if they loaned it out to Main Street. This is money going to the big banks.


(Moreover, top Fed officials have publicly stated that this policy of paying interest on excess reserves deposited at the Fed is intentionally aimed at reducing loans to Main Street, as a way to fight inflation.)

See documentation here and here.

Quantitative Easing

As I noted last August:



[The] Treasury Department encouraged banks to use the bailout money to buy their competitors, and pushed through an amendment to the tax laws which rewards mergers in the banking industry.
Yesterday, former Secretary of Labor Robert Reich pointed out that quantitative easing won't help the economy, but will simply fuel a new round of mergers and acquisitions:

A debate is being played out in the Fed about whether it should return to so-called "quantitative easing" -- buying more mortgage-backed securities, Treasury bills, and other bonds -- in order to lower the cost of capital still further.

The sad reality is that cheaper money won't work. Individuals aren't borrowing because they're still under a huge debt load. And as their homes drop in value and their jobs and wages continue to disappear, they're not in a position to borrow. Small businesses aren't borrowing because they have no reason to expand. Retail business is down, construction is down, even manufacturing suppliers are losing ground.

That leaves large corporations. They'll be happy to borrow more at even lower rates than now -- even though they're already sitting on mountains of money.

But this big-business borrowing won't create new jobs. To the contrary, large corporations have been investing their cash to pare back their payrolls. They've been buying new factories and facilities abroad (China, Brazil, India), and new labor-replacing software at home.

If Bernanke and company make it even cheaper to borrow, they'll be unleashing a third corporate strategy for creating more profits but fewer jobs -- mergers and acquisitions.

Similarly, Yves Smith reports that quantitative easing didn't really help the Japanese economy, only big Japanese companies:

A few days ago, we noted:

When an economy is very slack, cheaper money is not going to induce much in the way of real economy activity.

Unless you are a financial firm, the level of interest rates is a secondary or tertiary consideration in your decision to borrow. You will be interested in borrowing only if you first, perceive a business need (usually an opportunity). The next question is whether it can be addressed profitably, and the cost of funds is almost always not a significant % of total project costs (although availability of funding can be a big constraint)…..

So cheaper money will operate primarily via their impact on asset values. That of course helps financial firms, and perhaps the Fed hopes the wealth effect will induce more spending. But that’s been the movie of the last 20+ years, and Japan pre its crisis, of having the officialdom rely on asset price inflation to induce more consumer spending, and we know how both ended.

Tyler Cowen points to a Bank of Japan paper by Hiroshi Ugai, which looks at Japan’s experience with quantitative easing from 2001 to 2006. Key findings:

….these macroeconomic analyses verify that because of the QEP, the premiums on market funds raised by financial institutions carrying substantial non-performing loans (NPLs) shrank to the extent that they no longer reflected credit rating differentials. This observation implies that the QEP was effective in maintaining financial system stability and an accommodative monetary environment by removing financial institutions’ funding uncertainties, and by averting further deterioration of economic and price developments resulting from corporations’ uncertainty about future funding.

Granted the positive above effects of preventing further deterioration of the economy reviewed above, many of the macroeconomic analyses conclude that the QEP’s effects in raising aggregate demand and prices were limited. In particular, when verified empirically taking into account the fact that the monetary policy regime changed under the zero bound constraint of interest rates, the effects from increasing the monetary base were not detected or smaller, if anything, than during periods when there was no zero bound constraint.

Yves here, This is an important conclusion, and is consistent with the warnings the Japanese gave to the US during the financial crisis, which were uncharacteristically blunt. Conventional wisdom here is that Japan’s fiscal and monetary stimulus during the bust was too slow in coming and not sufficiently large. The Japanese instead believe, strongly, that their policy mistake was not cleaning up the banks. As we’ve noted, that’s also consistent with an IMF study of 124 banking crises:

Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.

Cross-country analysis to date also shows that accommodative policy measures (such as substantial liquidity support, explicit government guarantee on financial institutions’ liabilities and forbearance from prudential regulations) tend to be fiscally costly and that these particular policies do not necessarily accelerate the speed of economic recovery. Of course, the caveat to these findings is that a counterfactual to the crisis resolution cannot be observed and therefore it is difficult to speculate how a crisis would unfold in absence of such policies. Better institutions are, however, uniformly positively associated with faster recovery.

But (to put it charitably) the Fed sees the world through a bank-centric lens, so surely what is good for its charges must be good for the rest of us, right? So if the economy continues to weaken, the odds that the Fed will resort to it as a remedy will rise, despite the evidence that it at best treats symptoms rather than the underlying pathology.

Buying Bonds


So quantitative easing in general favors the big guys - by encouraging mergers and acquisitions, allowing them to take risky gambles and engage in other shenanigans - and doesn't help the economy as a whole.

But quantitative easing also provides a more direct bailout for the big banks.

Specifically, the current round of quantitative easing involves the Federal Reserve buying U.S. treasury bonds from the "primary dealers" - i.e. the biggest banks.

The Fed announces well in advance how much of what bonds it will be buying, and also buys the bonds in it's own name (not anonymously or through a proxy). That ensures that the banks can charge more for the bonds.

For example, as the New York Times notes:


“A buyer of $100 billion a month is always going to be paying top prices,” [Louis V. Crandall, the chief economist at the research firm Wrightson ICAP] said of the Fed. “You can’t be a known buyer of $100 billion a month and get a good price.”

In addition, people such as Jonathan Loman argue that the Fed is actually "gifting" the primary dealers with $5 billion dollars per month by intentionally overpaying for the bonds.

Too Big As Subsidy

The fact that the giant banks are "too big to fail" encourages them to take huge, risky gambles that they would not otherwise take. If they win, they make big bucks. If they lose, they know the government will just bail them out. This is a gambling subsidy.

For example, as the Special Inspector General of the Troubled Asset Relief Program said today:

When the government assured the world in 2008 that it would not let Citigroup fail, it did more than reassure the troubled markets -- it encouraged high-risk behavior by insulating risk-takers from the consequences of failure.


The very size of the too big to fails also decreases the ability of the smaller banks to compete. And - since the government itself helped make the giants even bigger - that is also a subsidy to the big boys (see this).


The monopoly power given to the big banks (technically an "oligopoly") is a subsidy in other ways as well. For example, Nobel prize winning economist Joseph Stiglitz said in September that giants like Goldman are using their size to manipulate the market:

"The main problem that Goldman raises is a question of size: 'too big to fail.' In some markets, they have a significant fraction of trades. Why is that important? They trade both on their proprietary desk and on behalf of customers. When you do that and you have a significant fraction of all trades, you have a lot of information."

Further, he says, "That raises the potential of conflicts of interest, problems of front-running, using that inside information for your proprietary desk. And that's why the Volcker report came out and said that we need to restrict the kinds of activity that these large institutions have. If you're going to trade on behalf of others, if you're going to be a commercial bank, you can't engage in certain kinds of risk-taking behavior."
The giants (especially Goldman Sachs) have also used high-frequency program trading which not only distorted the markets - making up more than 70% of stock trades - but which also let the program trading giants take a sneak peak at what the real (aka “human”) traders are buying and selling, and then trade on the insider information. See this, this, this, this and this. (This is frontrunning, which is illegal; but it is a lot bigger than garden variety frontrunning, because the program traders are not only trading based on inside knowledge of what their own clients are doing, they are also trading based on knowledge of what all other traders are doing).

Goldman also admitted that its proprietary trading program can "manipulate the markets in unfair ways". The giant banks have also allegedly used their Counterparty Risk Management Policy Group (CRMPG) to exchange secret information and formulate coordinated mutually beneficial actions, all with the government's blessings.

In addition, the giants receive many billions in subsidies by receiving government guarantees that they are "too big to fail", ensuring that they have to pay lower interest rates to attract depositors.

These are just a few of the secret bailouts programs the government is giving to the giant banks. There are many other bailout programs as well. If these bailouts and subsidies are added up, they amount to many tens - or perhaps even hundreds - of trillions of dollars.

And then there is the cost of debasing the currency in order to print money to fund these bailouts. The cost to the American citizen in less valuable dollars could be truly staggering.

And it is the top executives who reap the benefit of the bailouts through huge bonuses. Since the big banks continue to engage in highly-leveraged, risky, speculative activities, the bailouts have not made them any more stable. See this, for example.

[flow5]

Illinois companies are slamming the state's move to the third-highest corporate tax rate in the country, saying they are concerned about its effect on business.

But amid local budget shortfalls, other states might not find such tax hikes such a bad idea, and some tax policy experts said other Americans should brace themselves for inevitable tax increases in their states.

Joseph Henchman, tax counsel for The Tax Foundation in Washington, D.C., said the Illinois tax hike is only the beginning of what will be a tumultuous year for state tax rates.

"It will be quite an active year," said Henchman. "It might be a year of dramatic tax increases given the constraints states are under. There's always pressure to increase spending more than revenue growth, but the Tea Party and limited government dynamics will add to that pressure."

Henchman said other states that will definitely see tax increases are those in the worst fiscal trouble -- California and Maryland, and potentially New York.

But the new rate already is making waves in Illinois.

James O'Donnell, vice president of a manufacturing company outside of Chicago, said he is not just troubled but angry that legislators this week approved a 30 percent corporate tax rate increase. The rate increased to 9.5 percent from 7.3 percent, and the individual income tax increased to 5 percent from 3 percent, retroactive to Jan. 1, 2011.

"Someone asked me if this was that big of a deal, and I answered immediately, 'Yes, it definitely is a big deal,'" O'Donnell said. "It's bad for our employees, the future of our company, and it's not good for our customers either. This does nothing but increase our costs."

O'Donnell said his company, CamCraft Inc., had to make "painful decisions" in 2009 to stay afloat without raising customers' prices during the downturn. He said he is bitter that the state legislature did not do the same.

"The Illinois legislature made a very strong statement that they don't care about businesses and manufacturing," O'Donnell said.

He said his company, which has 275 employees and one facility in Hanover Park, Ill., may consider adding a second location in the future. And the Illinois tax increases give more reason to look outside the state.

Nick Kalivas, vice president of financial research with brokerage firm MF Global, said that the tax increase was an "anti-growth" measure.

"My concern from an economic standpoint is that gasoline prices are very high in Illinois, you've got fairly strict worker compensation laws, the regulatory environment is relatively stiff here, and you're taking money from the consumer," said Kalivas from his office in Chicago. "This tends to dampen the growth outlook."

The governors in Wisconsin and Indiana have been quick to comment on Illinois' tax increase. The neighboring states hope the increase will inspire businesses to move, with their tax revenue, to their states.
"We already had an edge on Illinois in terms of the cost of doing business, and this is going to make it significantly wider," Indiana Gov. Mitch Daniels told The Northwest Indiana Times last week.

The newly inaugurated governor in Wisconsin, Scott Walker, has used the slogan "Wisconsin Is Open for Business" since he was elected in November to try to lower his state's taxes.

Illinois' income tax increase to a flat 5 percent still is lower than Wisconsin's top income tax rate of 7.75 percent.

Doug Whitley, president of the Illinois Chamber of Commerce, said he was surprised by the size of the corporate tax increase, but he does not anticipate a "great fleeing of employers."

"I think it was a mistake personally. Illinois should never have a corporate income tax rate that is higher than your neighboring state," said Whitley. "The other big troubling concern about the action was there was no significant effort to cut spending or make any commitments to cut spending."

But other states also may move toward higher tax rates -- and at least one already has.

California Gov. Jerry Brown, in a effort to solve the state's fiscal crisis, increased the income tax for every bracket by 0.25 percent after a surcharge ended on Dec. 31, 2010.

California's state sales tax is set to drop one percentage point on July 1, but Brown has proposed a bailout initiative to extend the tax, which Henchman predicts will succeed.

Of the state tax increases in the country in 2010, Henchman said most were aimed at specific groups, including high-income earners, smokers or out-of-state business transactions

New Jersey's "millionaire's tax" income tax rates, which had a max of 10.75 percent, expired on Dec. 31, 2009. The new top rate is 8.97 percent, which matches that of New York.
The individual income tax rates of New York and New Jersey may look gargantuan compared to Illinois' new rate of 5 percent. But Henchman said Illinois' individual income tax was the last bastion of refuge from expensive taxes that is no more.

"It used to be the tax that balanced out all the other problems," said Henchman. "The corporate tax was kind of high originally. The sales tax was famously high and burdensome. The property tax was burdensome. Having that low income tax rate balanced those things, but now it won't."

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The prices investors are willing to pay for Illinois municipal bonds have strengthened in reaction to the sizeable tax increases approved by state lawmakers early Tuesday morning. It’s a signal that they are more comfortable with the state’s creditworthiness, investment experts say.

Gov. Quinn signed the bill Thursday that increased personal income-tax rates by 67 percent and corporate-tax rates by 45 percent. That boosted investors’ confidence in state-issued, tax-exempt and taxable bonds, said Alex Rorke, managing director and head of public finance at Loop Capital LLC, a Chicago-based investment bank.

“We think the legislation is a major positive move for investors,” Rorke said. “It shows that the state is taking the painful steps needed to strengthen the state’s credit.”

The price of Illinois’ credit default swaps--insurance against a bond default--fell more than 30 basis points to 295, its lowest point since Dec. 8, according to Markit Intraday, a global financial information services company.

A Markit spokesman said the drop is a good indicator that bonds have strengthened because it means it is cheaper to insure them.

Municipal bond investors had been steadily losing confidence in Illinois bonds in recent weeks as Wednesday’s deadline for the General Assembly to approve a fiscal bill grew nearer and a plan to cover the state’s pension obligations remained undefined. But after Tuesday’s vote, the bond market reflected a change in sentiment.

For example, a 2003-issued Illinois municipal bond with a 30-year maturity and coupon of 5.1 percent rose 1.5 percent in price on the secondary market between Tuesday and Wednesday after the income tax was approved, according to a bond trader at a Chicago-based investment management firm. The yield on this bond decreased 17 basis points one day after the tax increase was passed. The bond price rose to 80.83 cents on the dollar Thursday from a meager 76 cents two days before.

The state’s credit risk factors into bond prices, bond traders say. When bond prices rise, it reflects that traders believe risk has decreased. Ultimately this is good news for the state’s finances, indicating Illinois can offer new bonds with lower interest rates to entice investors.

Despite these signs, investment experts remain wary.

Fitch Ratings currently rates Illinois’ general obligation bonds “A” with a negative outlook. According to a statement from the rating agency, budgetary measures are needed to reduce the state’s accounts-payable balance. Fitch said it is waiting for more detail about the tax plan before providing a more long-term outlook.

Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management LLC in Oak Brook, echoed hesitant approval of the state’s tax increases.

“This action helps treat the systems but it’s no cure. It mitigates the cash flow stress in the near term, but doesn’t restore fiscal stability for the long term because lawmakers didn’t add significant spending cuts,” Ciccarone said. “I think it’s going to take a long time for the market to fully trust Illinois again.”

A measure to borrow an additional $8.75 billion to cover the state’s overdue bills did not pass the Illinois House Tuesday. A spokeswoman for the Office of Management and Budget said Gov. Quinn plans to revisit the measure within the next several weeks.

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Shanghai Composite Tumbles 1.3% On Latest 50 bps Reserve Requirement Ratio Hike By PBoC
Submitted by Tyler Durden on 01/14/2011 06:56 -0500

CitigroupIndiaJPMorgan ChaseMonetary PolicyMorgan StanleyWen JiabaoYuan


After the PBoC raised the RRR for the fourth time in two months (and 6 times in 2010), and following the Christmas Day interest rate hike, Chinese stocks once again find themselves reacquainted with gravity as the SHCOMP was trading down 1.3% at last check. The hike will be effective January 20 and will bring the RRR to a record 19%. And this most ineffective of monetary interventions will certainly not be the last: according to Bloomberg, "China may boost reserve ratios by more than 200 basis points in 2011, according to HSBC Holdings Plc economist Qu Hongbin. Industrial Bank Co. economist Lu Zhengwei estimates the ratio may reach 23 percent." Unfortunately, this latest move is too little too late, as Chinese food prices are already starting to make the politburo uneasy about what the world central bank cartel's actions mean for rice prices (remember the 3Rs as predicted by ZH - as we predicted in October, the next bubbles are Rare Earths, Rice, and Rubber).

From Bloomberg:

Today’s move, adding to the Christmas Day interest-rate increase, underscores Premier Wen Jiabao’s determination to tame inflation that may trigger social unrest. Officials may front- load monetary tightening to the first half of the year after deciding to shift to a “prudent” monetary policy, according to JPMorgan Chase & Co. and Morgan Stanley.

“With surging foreign-exchange inflows late last year and a possible rebound in bank lending in January, the central bank needs to ratchet up the reserve ratio to soak up liquidity,” Ken Peng, a Beijing-based economist at Citigroup Inc., said before today’s announcement. Inflation may quicken in January after easing in December from the fastest pace in more than two years, according to Peng.

China’s stocks tumbled today on concern monetary tightening may slow economic growth. The Shanghai Composite Index dropped 1.3 percent, bringing its loss over the past 12 months to 13 percent.

The following paragraph best describes the losing game that China is engaged in:

Wen’s government is trying to mop up liquidity as it limits gains in the exchange rate and enjoys a trade surplus and inflows of foreign capital. China’s foreign-exchange reserves climbed by $199 billion in the fourth quarter, to $2.85 trillion as of Dec. 31, the biggest quarterly gain since Bloomberg data began in 1996. Banks extended 7.95 trillion yuan ($1.2 trillion) of new loans last year, versus a target of 7.5 trillion yuan.

As for inflation: it's-a coming:

A survey released by the central bank in December showed Chinese consumers are more concerned about inflation than at any time in the past decade. Food costs climbed 11.7 percent in November from a year earlier, with Starbucks Corp. and McDonald’s Corp. among companies to have announced price increases in the past two months.

And while the world may not care about food riots in Tunisia, Algeria, and some parts of India, when it moves over to Beijing we have a feeling things will be just a little different.

======

Pressure continues. Sell Short.

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The only item in the Federal Budget Deficit that is untouchable (can't cut out), from an economic standpoint is the interest expense.

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The WSJ (Federal Reserve Market Data) Market Center shows deceleartion in the 13 week rates-of-change in both M1 & M2.
online.wsj.com/mdc/pub...

& MZM peaked on 12/13:
research.stlouisfed.or...

2010-12-06 9782.4
2010-12-13 9828.4
2010-12-20 9802.4
2010-12-27 9807.0

Required reserves have reversed direction & are now negative (i.e., the reserves of the larger "bound" commercial bank's).

=====
In the original federal reserve act of 1913 "It was anticipated that credit extended by the Federal Reserve Banks to commercial banks would rise and fall with seasonal and longer term variations in business activity"...

..."From the beginning, the Federal Reserve was reasonably successful in accommodating the seasonal swings in the demand for currency—in the terminology of the act, providing for “and elastic currency”
=====

Interpreted, the FOMC's policy of seasonal accommodation, and the resulting holiday mal-adjustments, are derived from the fallacious "real bills doctrine". I.e., recent price rises have been driven to a higher plateau (than they otherwise would be), by the FED, and these injections are now in the process of being "washed out". However, this holiday season looks weaker than previous times, i.e., price changes have been smaller, & have peaked earlier.

Sell short gold, crude oil, crb index, etc.

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"Thus the attempt to peg interest rates generates a dynamically unstable process in which money and prices chase each other upward ad infinitum in a cumulative inflationary spiral. ... Because of this the interest-targeting proposal may be viewed as merely the latest reincarnation of the discredited real bills fallacy." - Thomas Humphrey

"THE REAL-BILLS CRITERION SETS NO EFFECTIVE LIMIT TO THE QUANTITY OF MONEY" - Milton Fridman and Anna J. Schwartz "A Monetary History of the United States, 1867-1960"

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We are going to make millions shorting governments. Financial markets are setting up for an entry point around FEB month-end.

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There are three basic elements comprising long-term interest rates: (1) a “pure” rate; (2) a risk rate; (3) an inflation premium.

The pure rate presumably reflects the price required to induce lenders into parting with their money in a non-inflationary and risk-free situation.

The risk rate is measured by the yield curve in conjunction with the bond’s duration (counter-party credit quality, & repricing/liquidity, length to maturity, investment alternatives, etc.).

The inflation premium is the expected interest rate differential added to compensate for the future rate-of-change in inflation.

The truth is that the inflation premium injected into long-term yields is not a constant function of the rate of inflation. Real-yields vary as a function (depending upon the length of time), inflation is maintained within the FED's price-level mandate.

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BASED UPON y-o-y rates-of-change:

(1) Nominal gDp spiked in the 1st qtr of 2006.
(2) REAL-gDp made a double top (1st qtr of 2005 & 1st qtr of 2006).
(3) The implicit price deflator made a double top (3rd qtr 2005 & 1st qtr 2006).
======================...

I don't look at these numbers to trade (I checked the last 12 years only), but upon this examination, prices are always the leading indicator. Prices move before changes in production. Therefore: TARGET PRICES & not nominal gDp.

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Are the CBO's U.S. Debt Burden Projections Overly Optimistic?

The PolyCapitalist January 16, 2011 The Congressional Budget Office is estimating that annual interest payments on federal debt will more than double over the next decade to $778 billion.

Put another way, the U.S. will soon be paying federal debt interest (much of it to Asian and Middle East creditors) equal to the U.S.'s annual defense budget.

What assumptions lay behind the CBO's estimates? From the WSJ:

In 2010, it (the U.S. federal government) paid an average of about 0.1% interest on 3-month Treasury bills, and 3% on ten-year notes. Total net payments amounted to $197 billion, or 1.4% of annual economic output. That’s a bit more than what the government spent on unemployment insurance.

Low interest rates, however, won’t last forever — assuming the U.S. economy doesn’t succumb to long-term, Japanese-style stagnation. The CBO estimates that interest rates on 3-month bills and 10-year notes will reach 5.0% and 5.9%, respectively, by 2020. That, together with a rapidly rising debt load, would cause annual net interest payments to more than double by 2020 — to $778 billion, or a record 3.4% of GDP.

As bad as that sounds, I believe the CBO could be painting an overly optimistic scenario.

Whether the U.S. will actually be able to borrow long-term at a (historically) relatively low 5-6% interest rate in a decade's time is pure speculation by the CBO.

I'd also like to better understand why the CBO is projecting that U.S. interest rates across the yield curve will dramatically flatten? Right now the U.S. pays an interest rate of roughly 0.15% on 3-month borrowings, while the 10-year note is yielding 3.32%, for a difference of over 3% between short-term and longer-term borrowings. That's a pretty significant difference compared between the current level and the 0.9% difference the CBO is projecting in 2020.

If the U.S. continues its current debt trajectory is it reasonable to assume that it will be able to borrow long-term at a mere couple percentage points higher than today's levels?

Professor Barry Eichengreen is predicting that emerging financial powerhouses, such as China, will be able to offer a reserve currency alternative to the U.S. dollar by 2020. The U.S. is undoubtedly realizing lower interest rates right now due to the European sovereign debt crisis, and the lack of any real alternatives to the U.S. dollar as the world's primary reserve currency and the unparalleled liquidity of the U.S. treasuries market. What will happen when (not if) the situation changes?

Interest rates can certainly rise faster and/or higher than the CBO is projecting. A recalculation by the bond market of the U.S.'s credit worthiness can occur suddenly, as we saw last year with Greece. Professor Niall Ferguson for one is predicting that a U.S. fiscal crisis, similar to the one experienced by Greece last year, will occur within 2-4 years.

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Speeches
The Scope and Responsibilities of Monetary Policy
Presented by Charles I. Plosser, President and Chief Executive Officer, Federal Reserve Bank of Philadelphia
GIC 2011 Global Conference Series: Monetary Policy and Central Banking in the Post-Crisis Environment, The Central Bank of Chile, Santiago, Chile, January 17, 2011
PDF version (162 KB, 11 pages)

Introduction
I am delighted to speak before the Global Interdependence Center’s event today, and I especially want to thank Governor José De Gregorio and the Central Bank of Chile for hosting today’s conference. I have been trying to repay a visit that Governor De Gregorio made to the Philadelphia Fed for a GIC conference in 2008. And I am glad that our schedules finally made possible my first visit to this beautiful country.

As the title of the conference today suggests, Governor De Gregorio and I share some unique challenges in conducting monetary policy in a new world, a post-crisis world. Yet I believe some old lessons still apply. I would like to begin with a quote that some of you may recognize.

“...we are in danger of assigning to monetary policy a larger role than it can perform, in danger of asking it to accomplish tasks that it cannot achieve, and, as a result, in danger of preventing it from making the contribution that it is capable of making.”

Milton Friedman spoke these words in his presidential address before the 80th meeting of the American Economic Association in 1967.1 Although that was over 40 years ago, I believe Friedman’s caution is one well worth remembering, especially in this world where central banks have taken extraordinary actions in response to a financial crisis and severe recession. I believe the time has come for policymakers and the public to step back from our focus on short-term fluctuations in economic conditions and to think more broadly about what monetary policy can and should do.

It may help to put Friedman’s words into context. His remarks were directed at an economics profession that had gravitated toward believing that there was a stable and exploitable trade-off between inflation and unemployment — otherwise known as the Phillips curve. According to this view, policymakers should pick a point on the Phillips curve that balances the nation’s desire for low unemployment and low inflation. Friedman argued that this was a false trade-off and the experience in the U.S. in the decade that followed his remarks, often referred to as the Great Inflation, was a painful demonstration of Friedman’s valuable insight. In particular, that episode illustrated starkly that there was no stable relationship between inflation and unemployment. We learned the dangers inherent in monetary policies that take low inflation for granted in a world of high unemployment or perceived large output gaps. Our experiences clearly showed that efforts to manage or stabilize the real economy in the short term were beyond the scope of monetary policy, and if policymakers made aggressive attempts to do so, it would undermine the one contribution monetary policy could and should make to economic stability — price stability.

Of course, monetary theory has advanced in the past three decades with more sophisticated models and empirical methods to test the validity of these models. However, the proper scope of monetary policy remains an important issue today. In response to the global financial crisis, central banks have been asked to use monetary policy and other central bank functions to deal with an increasing array of economic challenges. These challenges include high unemployment, asset booms and busts, and credit allocations that fall more properly under the purview of fiscal policy. I believe we have come to expect too much from monetary policy. Indeed, broadening its scope can actually diminish its effectiveness. When monetary policy over-reaches and fails to deliver desired, but unattainable, outcomes, its credibility is undermined. That makes it more difficult to deliver on the goal it is actually capable of meeting. Moreover, when the central bank is asked to implement policies more appropriately assigned to fiscal authorities, the independence of monetary policy from the political process is put at risk, which also undercuts the effectiveness of monetary policy.

In my remarks today, I want to discuss the appropriate scope of monetary policy in dealing with real economic fluctuations, asset-price swings, and credit allocation. In doing so, I want to reinforce Friedman’s caution that we should be careful not to expect too much of monetary policy. I believe that if we recognize the limits to what monetary policy can do effectively, we will be better able to understand what monetary policy should do.

Before continuing, I should note that these are my views and not necessarily those of the Federal Reserve Board or my colleagues on the Federal Open Market Committee.

Monetary Policy and Real Economic Fluctuations
The U.S. Congress has established the broad objectives for monetary policy as promoting “effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” This has typically been characterized as the “dual mandate,” since if prices are stable and the economy is operating at full employment, long-term nominal interest rates will generally be moderate.

Most economists now understand that in the long run, monetary policy determines only the level of prices and not the unemployment rate or other real variables.2 In this sense, it is monetary policy that has ultimate responsibility for the purchasing power of a nation's fiat currency. Employment depends on many other more important factors, such as demographics, productivity, tax policy, and labor laws. Nevertheless, monetary policy can sometimes temporarily stimulate real economic activity in the short run, albeit with considerable uncertainty as to the timing and magnitude, what economists call the “long and variable lag.” Any boost to the real economy from stimulative monetary policy will eventually fade away as prices rise and the purchasing power of money erodes in response to the policy. Even the temporary benefit can be mitigated, or completely negated, if inflation expectations rise in reaction to the monetary accommodation.

Nonetheless, the notion persists that activist monetary policy can help stabilize the macroeconomy against a wide array of shocks, such as a sharp rise in the price of oil or a sharp drop in the price of housing. In my view, monetary policy’s ability to neutralize the real economic consequences of such shocks is actually quite limited. Successfully implementing such an economic stabilization policy requires predicting the state of the economy more than a year in advance and anticipating the nature, timing, and likely impact of future shocks. The truth is that economists simply do not possess the knowledge to make such forecasts with the degree of precision that would be needed to offset the economic shocks. Attempts to stabilize the economy will, more likely than not, end up providing stimulus when none is needed, or vice versa. It also risks distorting price signals and thus resource allocations, adding to instability. So asking monetary policy to do what it cannot do with aggressive attempts at stabilization can actually increase economic instability rather than reduce it.

Therefore, in most cases the effects of shocks to the economy simply have to play out over time as markets adjust to a new equilibrium. Monetary policy is likely to have little ability to hasten that adjustment. In fact, policy actions could actually make things worse over time. For example, monetary policy cannot retrain a workforce or help reallocate jobs to lower unemployment. It cannot help keep gasoline prices at low levels when the price of crude oil rises to high levels. And monetary policy cannot reverse the sharp decline in house prices when the economy has significantly over-invested in housing. In all of these cases, monetary policy cannot eliminate the need for households or businesses to make the necessary real adjustments when such shocks occur.

Let me be clear that this does not mean that monetary policy should be unresponsive to changes in broad economic conditions. Monetary policymakers should set their policy instrument — the federal funds rate in the U.S. — consistent with controlling inflation over the intermediate term. So the target federal funds rate will vary with economic conditions. But the goal in changing the funds rate target is to maintain low and stable inflation. This will foster the conditions that enable households and businesses to make the necessary adjustments to return the economy to its sustainable growth path. Monetary policy itself does not determine this path, nor should it attempt to do so.

For example, if an adverse productivity shock results in a substantial reduction in the outlook for economic growth, then real interest rates tend to fall. As long as inflation is at an acceptable level, the appropriate monetary policy is to reduce the federal funds rate to facilitate the adjustment to lower real interest rates. Failure to do so could result in a misallocation of resources, a steadily declining rate of inflation, and perhaps even deflation.

Conversely, when the outlook for economic growth is revised upward, real market interest rates will tend to rise. Provided that inflation is at an acceptable level, appropriate policy would be to raise the federal funds rate. Failure to do so would result in a misallocation of resources and, in this case, a rising inflation rate.

In both cases, changes in the federal funds target are responding to economic conditions in order to keep inflation low and stable and doing so in a systematic manner. Monetary policy is not trading off more inflation for less unemployment or vice versa. As I have already argued, the empirical and theoretical case for such a trade-off is tenuous at best. And the data to support the view that central banks can favorably exploit such a potential trade-off are even more dubious.

So what should monetary policy do? To strengthen the central bank’s commitment to price stability, I have long advocated that the Federal Reserve adopt and clearly communicate an explicit numerical inflation objective and publicly commit to achieving that objective over some specified time period through a systematic approach to policy. It is one of the messages of economic research over the last 40 years that policy is best conducted in a rule-like manner. This helps the public and the markets understand and better predict how policy will evolve as economic conditions change. This reduces volatility and promotes transparency and more effective communication.

An inflation objective coupled with a rule-like approach to policy decisions would make the central bank’s commitment more credible and policy more effective in achieving its goals. Indeed, the Federal Reserve is one of the few central banks among the major industrialized countries that have not made such a public commitment. I believe it is time we did. Such a commitment will help the public form its expectations about monetary policy, which would enhance macroeconomic stability.

Monetary Policy and Asset Prices
Let me now turn to the role of monetary policy in the evolution of asset prices. Some argue that monetary policy can be a source of distorted asset prices. That can be a problem, but it usually occurs when policy deviates from the sort of systematic policy rules that a price level or inflation target would suggest. Thus, a systematic approach to achieving price stability would help monetary policymakers avoid exacerbating the effects of asset-price swings on the economy. Putting aside monetary-policy-induced asset-price swings, I think it is fair to say that the broad view among many monetary policymakers is that asset prices should not be a direct focus of monetary policy. They generally accept the idea that various forms of prudential regulation or supervision are better suited to address such challenges, should it be called for, than monetary policy. Yet the housing boom, its subsequent collapse, and the financial crisis that followed have caused some to rethink this position concerning the scope of monetary policy.

No one takes issue with the view that asset prices are important in assessing the outlook for the economy and inflation. Movements in asset prices can provide useful information about the current and future state of the economy. Even when a central bank is operating under an inflation target, asset prices are informative. Put another way, judgments about the inflationary stance of monetary policy should be informed by a wide array of market signals, including asset-price movements.3 So while asset prices may be relevant in the normal course of monetary policymaking, the presumption is that such prices are responding efficiently and correctly to the underlying state of the economy, including the stance of monetary or fiscal policy. The bottom line of this view is that monetary policy should not seek to actively burst perceived asset bubbles.

Other people, especially in light of the recent financial crisis, advocate an active role for monetary policy to restrain asset-price booms. They tend to believe that asset prices are not always tied to market fundamentals. They worry that when asset values rise above their fundamental value for extended periods — that is, when a so-called bubble forms — the result will be an over-investment in the over-valued asset. When the market corrects such a misalignment — as it always does — the resulting reallocation of resources may depress economic activity in that sector and possibly the overall economy. Such boom-bust cycles are, by definition, inefficient and disruptive. So, the argument goes, policy should endeavor to prevent or temper such patterns.

This argument for monetary policy to respond directly to a perceived mispricing of specific assets is controversial. It requires that policymakers know when an asset is over-priced relative to market fundamentals, which is no easy task. For example, equity values might appear high relative to current profits, but if market participants expect profit growth to rise in the future, then high equity values may be justified.

Another challenge in addressing asset-price bubbles is that contrary to most of the models used to justify intervention, there are many assets, not just one. And these assets have different characteristics. For example, equities are very different from real estate. Misalignments or bubble-like behavior may appear in one asset class and not others and may vary even among a specific asset class. But monetary policy is a blunt instrument. How would policymakers have gone about pricking a bubble in technology stocks in 1998 and 1999 without wreaking havoc on investments in other asset classes? After all, while the NASDAQ grew at an annual rate of 81 percent in 1999, the NYSE composite index grew just 11 percent. What damage would have been done to other stocks and other asset classes had monetary policy aggressively raised rates to dampen the tech boom. During the housing boom, some parts of the U.S. housing market were experiencing rapid price appreciation while others were not. How do you use monetary policy to burst a bubble in Las Vegas real estate, where house prices were appreciating at a 45 percent annual rate by the end of 2004, without damaging the Detroit market, where prices were increasing at less than a 3 percent annual rate?

Because monetary policy is such a blunt instrument, asking monetary policy to do what it cannot do, such as seeking to deliberately influence the evolution of asset prices, risks creating more instability, not less. Moreover, the moral hazard created by the belief that the central bank would intervene if prices of a certain class of assets became “misaligned” might, in fact, cause more inefficient pricing and more instability, not less.

Monetary Policy and Credit Allocation
Finally, let me address another issue that has loomed large during the crisis and where great caution is required going forward — the role of monetary policy in credit allocation. At various times during the crisis, the Federal Reserve and many other central banks around the world intervened in various markets to facilitate intermediation. In many cases, these efforts were targeted to specific sectors of the economy, to specific types of firms, or in some cases, to specific firms.

Most of these efforts were justified on the grounds that central banks should act as “lender of last resort” in order to preserve financial stability. The specific criteria for undertaking these actions could not help but be somewhat arbitrary as policymakers had little experience with such a crisis, and little theory to guide them beyond Walter Bagehot’s dictum from the 1873 classic Lombard Street to limit systemic risk by “lending freely at a penalty rate against good collateral.”4 In general, these actions, especially in the U.S., involved extensive use of the central bank’s balance sheet and likely went far beyond what Bagehot would have imagined.

Even when it is appropriate for a central bank to function as a lender of last resort, it should follow a rule-like or systematic approach. This suggests announcing in advance the criteria that will be used to lend and who will be eligible to participate. Economic and financial stability would be best served by establishing such guidelines in advance and committing to following them in a crisis. That commitment is hard to deliver on, but institutional constraints can help tie the hands of policymakers in ways that limit their discretion. Most central banks, including the Fed, have not developed such systematic plans and thus behaved in a highly discretionary manner that generated moral hazard and volatility.

My purpose here is not to critique the myriad programs that were put in place or the varying degrees of moral hazard they created but to make a more general point — one that I have made before: that these actions, for the most part, are better thought of as forms of fiscal policy, not monetary policy, because they involved allocating credit and putting taxpayer dollars at risk. Moreover, asking monetary policy to do something that it should not do — engage in fiscal policy — can be detrimental to the economy by undermining monetary policy’s effectiveness at maintaining its ultimate responsibility: price stability.

A body of empirical research indicates that when central banks have a degree of independence in conducting monetary policy, more desirable economic outcomes usually result. But such independence can be threatened when a central bank ventures into conducting fiscal policy, which, in the U.S., rightly belongs with Congress and the Executive branch of government. Having crossed the Rubicon into fiscal policy and engaged in actions to use its balance sheet to support specific markets and firms, the Fed, I believe, is likely to come under pressure in the future to use its powers as a substitute for other fiscal decisions. This is a dangerous precedent, and we should seek means to prevent such future actions.5

I have long argued for a clear bright line to restore the boundaries between monetary and fiscal policy, leaving the latter to Congress and not the central bank. For example, I have advocated the elimination of Section 13(3) of the Federal Reserve Act, which allowed the Fed to lend directly to “corporations, partnerships and individuals” under “unusual and exigent circumstances.” The Dodd-Frank Wall Street Reform and Consumer Protection Act sets limits on the Fed’s use of Section 13(3), allowing the Board, in consultation with the Treasury, to provide liquidity to the financial system, but not to aid a failing financial firm or company.6 But I think more is needed. I have suggested that the System Open Market Account (SOMA) portfolio, which is used to implement monetary policy in the U.S., be restricted to short-term U.S. government securities. Before the financial crisis, U.S. Treasury securities constituted 91 percent of the Fed’s balance-sheet assets. Given that the Fed now holds some $1.1 trillion in agency mortgage-backed securities (MBS) and agency debt securities intended to support the housing sector, that number is 42 percent today. The sheer magnitude of the mortgage-related securities demonstrates the degree to which monetary policy has engaged in supporting a particular sector of the economy through its allocation of credit. It also points to the potential challenges the Fed faces as we remove our direct support of the housing sector.

Decisions to grant subsidies to specific industries or firms must rest with Congress, not the central bank. That is why I have advocated that the Fed and Treasury reach an agreement whereby the Treasury exchanges Treasury securities with the non-Treasury assets on the Fed’s balance sheet. This would transfer funding for the credit programs to the Treasury, thereby ensuring that policies that place taxpayer funds at risk are under the oversight of the fiscal authority, where they belong. And it would help ensure that monetary policy remains independent from fiscal policy and political pressure.

Conclusion
Although it has been over 40 years since Milton Friedman cautioned against asking too much of monetary policy, his insights remain particularly relevant today. I too am concerned that we are in the process of assigning to monetary policy goals that it cannot hope to achieve. Monetary policy is not going to be able to speed up the adjustments in labor markets or prevent asset bubbles, and attempts to do so may create more instability, not less. Nor should monetary policy be asked to perform credit allocation in support of particular sectors or firms. Expecting too much of monetary policy will undermine its ability to achieve the one thing that it is well-designed to do: ensuring long-term price stability. It is by achieving this goal that monetary policy is best able to support full employment and sustainable growth over the longer term, which benefits all in society.

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Milton Friedman & Plosser are fucking retarded. Economic forecasts ARE mathematically "precise" (Bernanke's term). Anyone who has glanced at bank debits could guess the current & expected state of economic affairs. I.e., monetary lags are "fixed". Monetary policy can be more "effective", etc.

The inequitable distribution of available credit (Detroit vs. Las Vegas)? That would make the "carry trade" an impossibility?

"monetary policy only determines the level of prices"? Then a corollary would be that it can't control the cost of credit? Because that's exactly the U.S. experience since 1965.

I.e., Greenspan never tightened monetary policy despite 17 hikes in the FFR over a 41 consecutive month period. The culminating peak in the y-o-y rate-of-change in nominal gDp coincided with Bernanke's Feb 2006 appointment (also corresponding to the peak in the rate-of-change in monetary flows - our means-of-payment money X’s its transactions rate-of-turnover).

Bernanke then tightened monetary policy for 29 consecutive months - not reversing policy when Bear Sterns 2 hedge funds collapsed, but waiting until Lehman Brothers filed for bankruptcy protection - driving our economy into a depression.

Now comes QE2: QE2 should once again, be an acknowledgement that that the FED must target the price level & not nominal gDp. The Reuters Jefferies/CRB weekly futures commodity price index has made a huge move. This demonstrates that prices precede changes in production (i.e., if there is an inflation-unemployment trade-off curve, it is shifting to the right, and at an accelerated rate). Or rather in this instance, that when the FED swapped assets, so did its counterparties.

What’s un-nerving? Bernanke in a 2002 speech said "The most striking episode of BOND-PRICE PEGGING occurred during the years before the Federal Reserve-Treasury Accord of 1951”…where…”the Fed enforced the 2-1/2 percent ceiling on long-term bond yields for nearly a decade WITHOUT EVER HOLDING A SUBSTANTIAL SHARE OF LONG-MATURITY BONDS OUTSTANDING"

But now the FED is now the largest holder of U.S. government debt.
Unless your retarded too, you understand that money flowing to the “Shadow Banking System” actually never leaves the commercial banking system. And that to reverse both disintermediation & deleveraging (the outflow of funds from the financial intermediaries), you could pull the same stunt as was successful in 1966. You increase the supply of loan-funds thereby decreasing long-term mortgage rates. I.e., you force the flow of funds from the CBs into the financial intermediaries (intermediary between saver & borrower).

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Richard Anderson V.P. St. Louis:

Emerging signs of stronger economic activity and the Federal Open Market Committee (FOMC)¡¯s second round of quantitative easing (QE2) have raised concern among some analysts that expansionary policy might be causing bubbles in financial and commodity markets¡ª bubbles that might harm the economy if they burst.

Prices for bonds, equities, and commodities have increased sharply since late August: The Reuters Jefferies/CRB weekly futures commodity price index increased by 22 percent (in U.S. dollars) through the week of November 9 (but fell sharply the following week), oil prices by 22 percent, the Economist food-price index by 20 percent, the Russell 2000 Index by 22 percent, and the broader S&P 500 Index by 15 percent (see charts).

Given these increases, the concern over bubbles is reasonable, but it is difficult to distinguish beforehand the line between aggressive (¡°just right¡±) monetary policy and overly aggressive (¡°too hot¡±) monetary policy that generates bubbles. Rapid increases in commodity and financial market prices by themselves, however, are not reliable indicators of potential bubbles because such increases also occur as part of normal monetary policy.

How exactly does policy operate in normal times when the federal funds rate is well above zero? The path begins with a reduction in the target rate, continues with changes in longer-term interest rates, and is followed by increases in real economic activity.1

Disappointingly low returns on short-term, low-risk investments prompt investors to move to longer-term, higher risk investments in financial instruments, commodities, and durable goods. In turn, bond and equity prices rise, decreasing corporate borrowing costs and increasing household wealth.

There also is a price effect: Broad expectations of higher prices for goods and services in future periods induce firms and households to spend money now rather than later.

And there are lags: Increasing the production of residential and nonresidential durable goods (including structures and durable equipment) takes time.

During this ¡°time to build,¡±2 both the size and duration of the difference between the contemporaneous prices of financial and real assets and their long-run values are larger, ceteris paribus, when monetary policy is more aggressively expansionary and increases in aggregate demand are stubbornly slow.

Eventually, as the economy rejoins its balanced growth path, bond prices fall (yields increase) as real interest rates and expected inflation increase.

Commodity price movements are more complex and involve several factors. One factor is the potential success of expansionary monetary policy: If economic activity expands, demand for commodities likely will increase, pushing futures prices upward, which in turn, tends to increase current period prices.

Further, some analysts have suggested the expansion of hedge funds and similar investments over the past decade may have increased the speed and volatility of commodity price changes.3

A second factor is the decreased foreign exchange value of the dollar as a result of aggressive monetary policy. Because most commodities are freely traded in international markets, commodity prices in U.S. dollars tend to increase as the dollar¡¯s value against other currencies falls.

As James Hamilton discussed in his blog on November 10, 2010, recent data show that changes in the U.S. dollar price of oil closely approximate changes in the dollar¡¯s exchange value against our trading partners.4 As long as the FOMC¡¯s pursuit of highly expansionary policy continues, households and businesses remain pessimistic, and demand is sluggish, the potential exists for asset prices to deviate from their long-run levels by large amounts and for long periods.

Such increases per se are not bubbles but a commonplace reaction of the monetary transmission mechanism. Yet, monitoring of prices is essential lest future adjustments be misunderstood by the public as part of the dynamics of aggressive monetary policy. Whether bubbles have been generated remains to be seen. ¡ö

1 During the mid-2000s, it was suggested that the transmission mechanism might have changed because longer-term market yields were dominated by international financial flows (e.g., see Thornton, Daniel T. ¡°The Monetary Policy Transmission Mechanism?¡± Federal Reserve Bank of St. Louis Monetary Trends, September 2005;
research.stlouisfed.org/publications/mt/20050901/cover.pdf).

Even if true then, the apparent success of the FOMC¡¯s QE program between March 2009 and March 2010 suggests this is no longer the case.

2 Kydland, Finn E. and Prescott, Edward C. ¡°Time to Build and Aggregate Fluctuations.¡± Econometrica, November 1982, 50(6), pp. 1345-70.

3 Basu, Parantap and Gavin, William. ¡°What Explains the Growth in Commodity Derivatives?¡± Federal Reserve Bank of St. Louis Review, January/February 2011, 93(1), pp. 37-48.

4 Hamilton, James. ¡°Commodity Inflation.¡± Econbrowser; November 10, 2010;
www.econbrowser.com/archives/2010/11/commodity_infla_2.html.
Economic SYNOPSES Federal Reserve Bank of St. Louis 2
research.stlouisfed.org

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Seven Factors That Will Slow U.S. Growth
Jan. 18 2011
Posted by John Mauldin

Long-time readers of my column are familiar with the names Dr. Lacy Hunt and Van Hoisington. They are a regular feature here, as quite frankly, anything that Lacy writes or says I pay serious attention to. This is their regular quarterly report, where they outline seven things that are likely to retard US growth. An easy read, but take the time to think this through.

Growth Recession Continues

Factoring in a 4% Q4 growth rate, the U.S. economy expanded by 3% in real terms from the 4th quarter of 2009 through the 4th quarter of 2010. Despite this rise in GDP, the unemployment rate remained stubbornly high at 9.6% in the last quarter of 2010, only slightly lower than the 10% rate it averaged in the same quarter one year ago. Positive real GDP growth with high unemployment is the definition of a growth recession. An even slower growth rate of real GDP should be recorded over the next four quarters, suggesting the unemployment rate will be essentially unchanged a year from now. As we have noted previously, this modest expansion is due to the significant over-indebtedness of the U.S. economy. We see seven main impediments to economic progress in 2011 that will slow real GDP expansion to the 1.5%-2.5% range.

First, fiscal policy actions are neutral for 2011. Second, state and local sectors will continue to be a drag on the economy and labor markets in 2011. Third, Quantitative Easing round 2 (QE2) will likely produce only a slight economic benefit as the Fed continues to encourage additional leverage in an already over-indebted economy. Fourth, while consumers boosted economic growth in the second half of 2010 by sharply reducing their personal saving rate, such actions are not sustainable. Fifth, expanding inventory investment, the main driver of economic growth since the end of the recession in mid-2009, will be absent in 2011. Sixth, housing will continue to be a persistent drag on growth. Seventh, external economic conditions are likely to retard U.S. exports.

Fiscal Policy in Neutral

The recent tax compromise between the President and Congress merely extended existing tax rates for another two years and provided a transitory 2% reduction in social security tax withholding. Personal taxes, including federal and non-federal, rose to 9.44% of personal income in November, up from a low of 9.1% in the second quarter of 2009 (Chart 1). Even with the tax compromise this effective tax rate will continue moving higher as a result of higher state and local taxes. Economic research has documented that temporary changes in tax rates are far less beneficial than permanent ones since consumers spend on the basis of permanent income. Higher outlays for unemployment insurance were also legislated, but these were negated by cuts in other types of spending. Federal spending through early March will mirror its pace in fiscal 2010, and the rest of the 2011 budget will decline slightly in real terms. Therefore, total real federal expenditures are likely to contract in real terms this year.

If fiscal policy becomes focused on long-run considerations (e.g. deficit reduction) economic conditions will improve over time. But, if fiscal policy remains focused on short-term stimulus, the economy’s prolonged under-performance will persist since the government expenditure multiplier is less than one, and possibly close to zero.

The recent scientific work on the expenditure multiplier is aligned with the Ricardian equivalence theorem as well as the views of the Austrian economists who continued to follow Ricardo even when the Keynesian revolution was ascendant. Economist Gary Shilling made this point very well in his outstanding new book, The Age of Deleveraging – Investment Strategies for a Decade of Slow Growth and Deflation.

Dr. Shilling’s analysis of the simplified and unsubstantiated Keynesian multiplier (p.216) still taught in many colleges and universities is extremely insightful. “But the Austrian School of economists like Friedrich Hayek and Ludwig von Mises believed that the economy is much more complicated; The Austrian view suggests that the government spending multiplier may be only 1.0 and that there are not any follow-on effects. More recent academic studies indicate that the multiplier is less than 1.0, and perhaps much less.”

After recognizing the difficulty of calculating the multiplier, Dr. Shilling writes, “Also, the inherent inefficiencies of government reduce the effects of deficit spending and lower the multiplier.” Thus, if steps are taken to reduce deficit spending, the economy’s growth rate will recover after the initial transitory negative impact as additional resources are provided to the private sector.

State and Local Governments Drag

Municipal governments face substantial cyclical deficits and significant underfunding of their employee pension plans. In addition, municipal bond yields rose sharply in the second half of 2010, increasing borrowing costs, probably an unintended consequence of QE2. The municipal bond market proceeds are used primarily for funding capital projects, which suggests that such projects will be delayed. State and local governments typically do not undertake capital projects freely when they have large cyclical deficits.

To reign in these financial imbalances, state and local governments have five choices: (1) cut personnel; (2) reduce expenditures including retirement benefits; (3) raise taxes; (4) borrow to fund operating deficits; or (5) declare bankruptcy. All retard economic growth. Any trend toward increased bankruptcy would raise caution in the broader municipal market and add to higher borrowing costs. Raising taxes may give bondholders more confidence, but such actions can fail to raise new revenue as slower economic conditions retard spending. The demographic trends in the decennial census also show that people are increasingly moving to low tax regions, contributing to worsening fiscal imbalances from the exited areas.

QE2’s Problems

Clearly, Fed actions have affected stock and commodity prices. The benefits from higher stock prices accrue very slowly, are small, and are slanted to a limited number of households. Conversely, higher commodity prices serve to raise the cost of many basic necessities that play a major role in the budget of virtually all low and moderate income households.

For example, in late 2010 consumer fuel expenditures amounted to 9.1% of wage and salary income (Chart 2). In the past year, the S&P GSCI Energy Index advanced by 14.6%. Since energy demand is highly price inelastic, it seems there is little alternative to purchasing these energy items. Thus, with median family income at approximately $50,000, annual fuel expenditures rose by about $660 for the typical family. In late 2010, consumer food expenditures were 12.6% of wage and salary income. In the past year, the S&P GSCI Agricultural and Livestock Commodity Price Index rose by 40%. If we conservatively assume that just one quarter of these raw material costs are ultimately passed through to consumers, higher priced foods will have added another roughly $626 per year of essential costs to the median household budget. These increased costs could be considered inflationary, however, with wage income stagnant, higher food and fuel prices will act like a tax increase. Indeed, the approximately $1300 increase in food and fuel prices is equal to 2.6% of median family income, an amount that more than offsets the 2% reduction in the social security tax for 2011.

Reflecting the inflationary psychology of the higher stock and commodity prices, mortgage rates and municipal bond yields have risen significantly since QE2 was first proposed by the Fed chairman, increasing the cost and decreasing the availability of credit for two sectors with serious underlying problems. Also, Fed policy has pushed most consumer time, money market, and saving deposit rates to 1% or less, thereby reducing the principal source of investment income for most households. Clearly the early read on QE2 is negative for the economy.

Substitution Effects

In a November speech in Frankfurt, Germany, Dr. Bernanke said that the use of the term “quantitative easing” to refer to the Federal Reserve’s policies is inappropriate. He stated that quantitative easing typically refers to policies that seek to have effects by changing the quantity of bank reserves. These are channels that the Chairman considers relatively weak, at least in the U.S. context. Dr. Bernanke goes on to argue that securities purchases work by affecting yields on the acquired securities in investors’ portfolios, via substitution effects in investors’ portfolios on a wider range of assets. This may well be true, but the substitution effects are just as likely to be detrimental (i.e. the adverse implications of increasing commodity prices and rising borrowing costs for some and reducing interest income for others). Importantly, the Fed has no control over these substitution effects.

In his reputation-establishing 2000 book, Essays on the Great Depression, Dr. Bernanke argues that “some borrowers (especially households, farmers and small firms) found credit to be expensive and difficult to obtain. The effects of this credit squeeze on aggregate demand helped convert the severe, but not unprecedented downturn of 1929-30 into a protracted depression.” Interestingly, when QE2 drives up borrowing costs for homeowners and municipalities, thereby restricting credit, the Fed is creating (according to Dr. Bernanke’s book) the exact same circumstance, albeit on a reduced scale, that helped cause the great depression—rather bizarre!

Liquidity Mistakes

For the past twelve years the Fed’s policy response to economic problems has been to pump more liquidity. These problems included: (1) the failure of Long Term Capital Management in 1998; (2) the high tech bust in 2000; (3) the mild recession that began with a decline in real GDP in the fall of 2000; (4) 9/11; (5) the mild deflation of 2002-3; (6) the market crisis and massive recession and housing implosion of 2007-9; and now, (7) the lack of a private-sector, self-sustaining recovery.

The Fed diagnosed each of these events as being caused by insufficient liquidity. Actually, the lack of liquidity was symptomatic of much deeper problems caused by their own previous actions. The liquidity injected during these events led to a series of asset bubbles as the economy utilized the Fed’s largesse to increase aggregate indebtedness to record levels. The liquidity problems arose as the asset bubbles burst when debt extensions could not be repaid and generally became unmanageable. Each succeeding calamity or bust reflected reverberations from prior Fed actions.

While governmental directives to Fannie and Freddie to increase home ownership clearly also played a role, the Fed supported this process by providing excessive liquidity to fund the housing bubble as well as other unprecedented forms of leveraging of the U.S. economy. The heavy leveraging and the associated asset bubbles, however, produced only transitory and below trend economic growth. Similarly, like its predecessors, QE2 is designed to cure an over-indebtedness problem by creating more debt.

In addition to failing to revive the economy permanently, major unintended consequences have arisen. The LTCM bankruptcy created a $3 billion loss, a very modest amount in view of the sums required by subsequent bailouts. The Fed’s reaction to LTCM served to give market participants a signal that the Fed would back-stop those regardless of whether they engaged in or enabled bad behavior. Also, Fed actions have conditioned Wall Street to seek Fed support whenever stock prices come under downward pressure. In fact, the process of leaking out QE2 began in the midst of a stock market sell off.

Well-intentioned actions to promote growth and fine tune the economy by micromanagement have instead produced failure. Although the Fed had little choice in massively supporting financial markets in 2007/8, no Fed intervention would have been a more long-term productive stance in the previous economic events. QE2 is another example of flawed Fed policy operations.

The Saving Rate Decline

In the second half of 2010, real GDP grew at an estimated 3.3% annual rate (assuming the fourth quarter growth rate was 4%), up from 2.7% in the first half of the year. Transitory developments in two of the most erratic and unpredictable components of the economy—the personal saving rate and inventory investment—accounted for all of this acceleration.

From 6.3% in June 2010, the personal saving fell by a significant 1%, to 5.3% in November (Table 1). Consumer spending is slightly in excess of 70% of real GDP. Without the one percentage point reduction in the personal saving rate, the second half growth rate would have been 2.6%, a shade slower than the first half growth pace, and materially less than the presumed second half growth rate.

When job insecurity is high, and defaults, delinquencies and bankruptcies are at or near record levels, a drawdown in the saving rate would seem to be an unlikely event. This development is certainly viewed favorably by retailers but the issue is whether the economy’s future is better served by using the funds to make mortgages current, pay other debts and prepare consumers for potential emergency needs. Thus, the lowering of the saving rate is similar to running monetary and fiscal policy to meet short-run needs while ignoring long-term consequences.

Inventory Reversal

Inventory investment was the main driver of economic growth since the recession ended in mid-2009. Based on published data, real GDP grew at a 2.9% annual rate over this span. However, real final sales, which excludes inventory investment from GDP, increased at a paltry 1.1% pace. In the third quarter, inventory investment surged to 3.7% of GDP while preliminary fourth quarter figures on retail, wholesale and manufacturing inventories indicate this figure might have reached 4% (Chart 3). In the final quarter of the recession, inventory investment was -5.1% of GDP. Since 1990, the period of modern inventory control mechanisms, inventory investment averaged only 1.1%. At a minimum, the dominant source of aggregate economic strength will not repeat in 2011.

Housing Drag Persists

Housing will remain a drag on economic activity in 2011. Prices have re-accelerated to the downside over the past four months, as mortgage yields have risen and the housing overhang has increased. The housing overhang, as explained by Laurie Goodman writing in the Amherst Mortgage Insight, “is not caused solely by the number of non-performing loans that exist in the market. The problem also includes the high rates at which re-performing loans are re-defaulting, along with the relatively high rates at which deeply underwater loans that have never been delinquent are running two payments behind for the first time.”

Another major problem is that home prices are still too high. An excellent and well-researched study by Danielle DiMartino Booth and David Luttrell in the December 2010 Economic Letter from the Dallas Fed documents this issue very authoritatively. Booth and Luttrell write, “As gauged by an aggregate of housing indexes dating to 1890, real home prices rose 85% to their highest level in August 2006. They have since declined 33 percentÉ In fact, home prices still must fall 23% if they are to revert to their long-term mean.”

From the standpoint of most households, the home is the main component of wealth, not stock market investments. The continuing drop in housing prices serves to underscore the ill advised and likely temporary drop in the personal saving rate that was so critical to economic performance late last year.

Adverse Global Considerations

The global economy since 2009 may be referred to as a two-speed recovery, with China, India, Brazil, and other emerging economies at the high speed and the U.S. and Europe at the slow speed. That pattern is likely to continue, but with an important difference. China, India, and Brazil are likely to slow adversely affecting the U.S. and Europe. Thus, the two-speed recovery will continue, but with the entire world growing at a much more modest pace. Two major considerations point to this outcome. First, the higher food and fuel prices discussed earlier will serve to significantly depress growth in countries like China, India and Brazil where food and fuel are known to be a much higher percentage of household budgets. Already reports have surfaced from international agencies on the growing adverse consequences of higher food prices, and social unrest has also been witnessed on a limited basis.

Second, Chinese economic policy is designed to slow growth and reduce inflationary pressures. Although the People’s Bank of China (PBoC) has already taken several actions to contain surging inflation, more steps may be needed. In China, as elsewhere, inflation is a lagging indicator. It is worth considering that the PBoC has never been able to engineer a soft landing, which suggests that ultimately a downturn in China may be greater than the prevailing consensus.

Thus, changing global conditions should serve to moderate U.S. exports. Ironically, the U.S. current account deficit still may continue to improve. A stabilization of the saving rate will reduce U.S. imports, while a higher saving rate will cut imports significantly. Already this two-speed global economy has resulted in a reduction in the U.S. current account deficit of approximately 3% of GDP (Chart 4). A continuation of this trend will serve to underpin the value of the dollar, which rose in 2010. The firm dollar, in turn, will serve to keep U.S. disinflationary trends intact.

Bond Market Conditions

In spite of the adverse psychological reaction to the QE2, long Treasury bond yields dropped to 4.3% at the end of 2010, down 30 basis points from the close of 2009, producing a total return of slightly more than 10% for a portfolio of long Treasury and zero coupon bonds. The problematic economic environment and its depressive effect on inflation suggests long Treasury bond yields could easily decrease another 30 basis points in 2011, which would produce another double-digit rate of return for a similar portfolio. The probabilities of even lower yields are significant

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The stock market keeps rising "as if propelled by some mysterious force," Tuesday's Wall Street Journal quotes one incredulous analyst. Equities are indeed being pushed higher by an inexorable force, but one that's no mystery -- money.

The U.S. stock market's total value has increased by over 25% -- some $3.2 trillion -- since Aug. 26, based on the Wilshire 5000, the broadest measure of the market. That date was prior to Federal Reserve Chairman Ben Bernanke's speech to the central bank's Jackson Hole, Wyo., policy pow-wow, when he first laid out the justification for the Fed's purchases of Treasuries now known by all as QE2, the folks at Wilshire Associates remind us.

That's not a bad payoff, especially considering the Fed is less than half way through the program to buy up to $600 billion of Treasuries by the end of June. Too bad that bond yields and mortgage interest rates actually are higher since QE2 departed its slip, but that falls under the category of collateral damage.

As Bernanke explained in an op-ed piece in the Washington Post on Nov. 4, the day after the Federal Open Market Committee formally approved QE2, "higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending."

This so-called wealth effect, of course, is confined to those invested in equities, who tend to shop at Saks (ticker: SKS) and Tiffany (TIF). The inverse, which one supposes should be dubbed the poverty effect, is felt by those who have to pay higher prices for fuel and food that have followed the Fed's liquidity expansion from its Treasury purchases. Stores that cater to hoi polloi have seen sales fall short of projections, leading to labored performance for their stocks, as Michael Kahn's Getting Technical column points out.

Another effect of QE2, observes RBC Capital Markets, is that "the Fed is now far and away the biggest buyer and holder of Treasuries," at well over $1 trillion. As a result, the federal government is able to finance its budget deficit effortlessly, as the Fed effectively buys as many securities as the Treasury sells.

It also means the Fed thus has supplanted China as the largest holder of U.S. government debt, which is not an unalloyed advantage to America. True, one arm of the U.S. government is creditor to the U.S. government. But it means that the debt is being monetized -- paid for by money that is figuratively printed but literally conjured out of thin air.

Which is just as well, since China has been paring its holding of U.S. government securities. According to the latest Treasury International Capital data released Tuesday, China reduced its holdings of Treasury securities due in one year or less by over $21 billion in November, when QE2 launched. While China boosted its holdings of Treasuries due in more than one year by $10 billion, the yield on the benchmark 10-year note started its ascent in earnest, to over 3.50% in mid-December from under 2.50% in early November.

Even though it has been supplanted by the Fed as the No. 1 holder of Treasuries, China's role as a supplier of global liquidity remains considerable.

As a result of its purchases of Treasuries, which swell the balance sheet of the People's Bank of China, the nation's central bank, China's M2 money supply has exploded by 148% from January 2007 to December 2010, to $11.2 trillion from $4.5 trillion. U.S. M2 has expanded "just" 25%, to $8.8 trillion from $7.1 trillion over that span. Those revealing numbers are brought to light by International Strategy & Investment, headed by the lynx-eyed Ed Hyman.

The irony of all this is that as President Obama meets China's leader, Hu Jintao, their respective monetary policies will be the key point of contention. Not the usual topic of conversation among world leaders, but one of crucial importance to heads of the No. 1 and No. 2 nations in economic terms.

The U.S. accuses China of keeping its currency, the renminbi or yuan, undervalued -- which it does by buying Treasuries with dollars bought up with yuan. China says the dollar-centric international monetary system is an artifact of history and the greenback no longer is a reliable store of value because of American monetary and fiscal excesses.

Expansionary U.S. monetary policy is necessarily imported by China as long as it effectively pegs the RMB to the dollar; excess greenbacks are bought by China, which prints RMB to do so. Chinese monetary authorities are attempting to offset the exchange-rate effect on monetary policy by raising bank reserve requirements and interest rates. China's stock market reflects this move to a less easy policy.

The Fed, for its part, will almost certainly complete its QE2 purchases of $600 billion. The question becomes, then what? A sticky unemployment rate will boost pressures for QE3, even if it is a smaller vessel than QE2.

Or will the inflationary consequences of massive money printing on both sides of the Pacific induce central banks to change courses? In developed economies, higher food and fuel prices mean reduced discretionary incomes and curtailed spending on other items. In developing countries, price hikes for food already is sparking riots.

For now, money printing is the mysterious propellant for stock prices. How long it lasts until it fizzles is another question.

Randall Forsyth - Barrons
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I guess China made a bad interest rate swap (betting on QE2).

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Oversight Plan Seen to Lack Specifics By VICTORIA MCGRANE And AARON LUCCHETTI
WASHINGTON—Top federal regulators inched forward in their implementation of the new financial regulatory law, but didn't provide the clarity banks and others are seeking on two critical provisions.

Regulators issued a series of recommendations on how to implement the "Volcker rule," a provision that restricts financial firms from trading with their own money. They also approved and released a draft rule setting out the framework for deciding which large financial companies, other than banks, are risky enough to warrant tighter scrutiny.

Both documents were largely open-ended and deferred key decisions to regulators charged with crafting the specifics.

"Those that thought today would bring clarity to the regulatory landscape were highly disappointed," said Jaret Seiberg, an analyst with MF Global's Washington Research Group.

On the Volcker rule, the new Financial Stability Oversight Council, comprising top federal financial regulators and the Treasury, issued a study that included 10 actions they "strongly" recommend regulators take into consideration as they implement the provision.

Named for former Federal Reserve Chairman Paul Volcker, it seeks to prevent banks from putting capital at risk by prohibiting proprietary trading and banning certain relationships with hedge funds and private-equity funds.

As expected, the study didn't recommend a precise review of each trade to see if it complies with the law. But it did recommend firms flag each trade in a variety of ways, including whether a customer or the trader initiated the position.

Read Documents From Oversight Council
.The council acknowledged it is difficult to distinguish between prohibited proprietary trading and a permitted activity, such as market-making, hedging or some other trade done on behalf of a bank's client.

Sorting out this "grey area" will be the key focus for the individual agencies, said Mary Miller, Treasury assistant secretary for financial markets, during the open meeting.

The study recommends requiring banks to close proprietary trading desks, since their activity is unambiguously in violation of the Volcker rule. This is already happening. Major Wall Street firms, including Goldman Sachs Group Inc. and Morgan Stanley, have seen high-profile traders depart or plan to start new firms in anticipation of the new restrictions.

The study also recommends banks be required to set up internal controls and compliance regimes.

One new wrinkle getting notice on Wall Street: The study recommends company chief executives attest to their company's compliance, signaling how important the council considers the Volcker provision.

The industry fought hard for regulators to resist an approach that would choke off trading with clients and, in some ways, they won on this point. Regulators seemed willing to allow Wall Street firms to draft the initial compliance programs.

The study's approach "empowers the industry to write a bottoms-up program that reflects how things are done," says William Sweet, a partner at Skadden, Arps, Slate, Meagher & Flom LLP. The big question now is how regulators will greet each firm's plan to comply with the Volcker Rule.

The Securities Industry and Financial Markets Association, a Wall Street trade group, said in a statement that it appreciated the study avoiding a "one-size-fits-all" approach in trading, but added that the recommendations "are the first step in a complicated process" that it hopes will ensure trading such as hedging and market-making that it views as "critical to well functioning markets."

In its second major move, the council voted to approve a draft proposal on the framework it would use to determine which financial companies merit heightened government scrutiny, a first step toward preventing "too big to fail" firms from dragging down the economy. The proposal listed six factors the council would use to help it judge whether a company is "systemically important."

Industry officials said the proposal put very little meat on the bones. Mr. Seiberg, the analyst, that there was nothing in the rule that market participants could use to sort out which firms were likely to get the designation and which are not. Being designated by the council subjects the firm to supervision by the Federal Reserve.

Analysts speculate that large insurance companies, hedge funds and GE Capital could be subject to the new regulatory regime.

The rules now get kicked back into the regulatory process. For the Volcker rule, regulators have nine months to implement detailed regulations for the institutions they oversee, setting mid-September as the due date.

The proposal discussing which firms should be regulated by the Fed is now sent to a 30-day comment period. A Treasury official said the council should be ready to issue its final rule by late spring or early summer.

Treasury Secretary Timothy Geithner said the reports and draft rule released Tuesday "mark another step in building the foundation for the reforms that Congress legislated." He also said he believes the U.S. is "substantially ahead" of the world's other major financial centers in addressing the financial crisis.

Also Tuesday, the Treasury released a broad-brush assessment of new rules requiring banks that bundle loans to hold some credit risk on their balance sheets. The goal is to encourage banks to make more prudent loans. The study, also mandated by the Dodd-Frank law, was similarly shy of specifics.

The Treasury said it couldn't assess whether the new rules would have helped prevent the housing bubble, citing a lack of data and the fact that regulators haven't yet issued the rules.

====

Which came first the chicken or the egg? Any issue having a widespread domestic economic impact will also have to be "validated" by monetary policy.