The Market Ticker
Commentary on The Capital Markets- Category [Federal Reserve]
2015-08-30 06:00 by Karl Denninger
in Federal Reserve , 291 references
 

Hmmmm...

Clearly, the Fed has essentially achieved its employment objective, but it is somewhat below its self-selected objective of 2% inflation. Congress clearly specified the inflation goal for the Fed by calling for “price stability.” Since 2012, the Fed has redefined this congressionally mandated goal of no or zero inflation as being represented by 2% inflation of the Consumer Expenditure Survey. In fact, 2% inflation will double the price level every 35 years. This hardly represents price stability.

....

Robert Heller

Belvedere, Calif.

Mr. Heller is a former governor of the Federal Reserve System

Mr. Heller was nominated by Ronald Reagan in 1986 and confirmed unanimously.

Note that he has called out exactly the same point I have since I started writing this column -- that the actions of The Fed have been unlawful.  

More to the point said unlawful behavior has been policy and worse, it has been essentially continual since The Fed was formed.

To those who say that this points to The Fed as an "evil" institution may I point out that no law means anything if there is nobody who will enforce it.

There are 535 jackasses currently infesting Washington DC that are quite capable of enforcing their own law.  They can do so as they have absolute control over the authority of said Fed, can revoke its charter at any time and further can de-fund it any time they'd like.  They can also add an "or else" (in other words, criminal sanction for violations) to the Federal Reserve Act and then refer the entire Board of Governors to the FBI for arrest and prosecution.

The problem does not lie in The Fed.

It lies in Congress, and since we directly vote for those who are in Congress, and we continue to sit for the rank and outrageous theft that takes place through the acts of this body, with the full consent of Congress, the fault is ours.

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The amusement is strong from this one....

The economy has made great gains and is approaching an acceptable normal. Policy should shortly acknowledge this reality. The Fed took extraordinary policy measures in response to extraordinary economic conditions. Conditions are no longer extraordinary.

Compared to earlier in the year, we know a lot more and can shelve some concerns. We appear to be past the most acute concerns of a spillover from Europe. I have more confidence in the resilience of the economy today compared to even a few months ago. I am much less concerned about a reversal of economic fortune. We are getting closer and closer to what feels like a healed state of the economy.

For me, the cumulative evidence of the economy's healing, and the likelihood the economy is on a path to achieving the Fed's mandated objectives, makes me comfortable that the economy can handle a gradually rising interest-rate environment.

Fed Chair Janet Yellen has stated she expects conditions to jell, justifying a start to policy normalization sometime later this year. I agree. I think the point of liftoff is close.

As the Committee approaches what I consider a historic decision, I am not expecting the data signals to point uniformly in the same direction. I don't need this. I'm prepared to see mixed data. Data are inherently noisy month to month and quarter to quarter. Given the progress made over the recovery and the overall recent tone of the economy, I for one do not intend to let the gyrating needle of monthly data be the decisive factor in decision making.

Read the entire piece; this set of paragraphs is just one of amusingly-idiotic prose, full of rationalization but bereft of recognition.

Here's reality: A "normalization" of policy means removal of several trillion in assets from The Fed's balance sheet.  To whom will those assets be sold, at at what price?  Since bond yields are the inverse of price, such a flood into the market will inevitably drive yields much higher, and faster, than is being discussed.

But the problem doesn't lie with whether the economy "can handle" such a move or not.  It lies in what happens to all of those who have borrowed through doubling-down into a 30-year+ declining rate environment.

Let me remind you how this can work and has over the last ~30 years -- all the way back to the very high inflation days of the early 1980s.

Let us say you borrow $1 million at an interest rate of 10% (which, I remind you, was a very good rate at that time.)

You must pay $100,000 in interest a year to keep that money outstanding.

Now the rate of interest falls to 5%.  You could pay $50,000 in interest, or you could borrow another million and spend it, keeping the payment at $100,000.  Which do you think both corporations and governments did?  They borrowed the second million and spent it.

Now the rate falls to 2.5%.  You could once again pay $50,000 in interest, or you could borrow another two million.  Again, what do you think they did?  Yes, there is now four million outstanding that has been spent!

This continues until today, when "good credits" can borrow at 1%.  Instead of $1 million you can now have $10 million outstanding, and most of these firms and governments do.  

Now the punch line: What happens when the rate of interest goes to 2% for those "good credits" -- a mere 1% rise?

The interest payment required to keep the $10 million outstanding doubles to $200,000.  If you can't come up with it then only way to reduce it, other than bankruptcy, is to pay down $5 million of the $10 you have out.

But you don't have $5 million; you spent it.  That was, after all, the entire point of borrowing it!

This is the trap and from the size of it you can see the problem The Fed has.  Even a modest interest in rates, to say 1%, will drive "good credit" borrowing costs in the short term to roughly 2% or so, which will instantly double the interest due or force a paydown of half of the debt outstanding.

The latter is impossible and so is the former.

By the way, a huge percentage -- half or more -- of the move in stock prices is directly related to this outrageously low interest rate environment.  When it ends so will the fuel for said appreciation -- but equally important, even if The Fed holds and does nothing it is not the low rates but the move lower in rates, which now cannot continue as zero is a fixed lower boundary, that drove the move in the first place.

Next question for you: What happens when the "blip" in Chinese data turns into an all-on rout and comes back around through Europe and the United States before The Fed has shed its balance sheet assets and returned short-term rates to the long-term average around 5%?

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One thing I've said repeatedly over the years is that on the evidence The Fed doesn't actually "set" rates; rather, it follows the market.

This is not universally true, but an overlay of actual short-term rates with the Fed Funds rate shows that most of the time, by a wide margin, the market moves first and the Fed basically gets dragged by the nose in the direction the market wishes to go.

If you think about it this makes sense; nobody can subsidize an uneconomic transaction forever, yet this is exactly what you'd have to do if you were going to "fight" the market on a permanent basis.  Either you can lead the market or you can't, but if you can't then you must conform to it because otherwise you will run out of money -- it is simply a matter of when.

So with that backdrop, you might want to read this...

NEW YORK (Reuters) - As traders, market pundits and economists jaw over whether the Federal Reserve this year will lift its benchmark lending rate for the first time in almost a decade, several corners of the U.S. bond market are not waiting around.

A wide range of short-term interest rates, which tend to be the most sensitive to Fed policy expectations, has been quietly grinding higher for weeks, or in some cases much longer. Several have even surpassed their levels of two years ago during the bond market's "taper tantrum," when prices dropped steeply and yields shot up as the Fed pondered whether to halt its massive asset-purchase program.

This has nothing to do with what traders "expect"; it has everything to do with the fact that below-market rates rob people and eventually those who are getting robbed revolt by demanding a higher coupon!

The Fed wants you to believe that it can drag the market around by the nose.  It cannot; at best it can jawbone and threaten, and if you believe them then you will do what they want.

But if not it is The Fed, not the market, that has to make the adjustment.

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