Fed Starting to Unwind Loose Monetary Policy, Could Trigger Secondary Recession
Economics / Money Supply Jan 27, 2010 - 01:21 AM GMTBy: Gary_North
Officials at the Federal Reserve System insist that the FED will unwind its more than doubled monetary base. They do not say when. They do not say how. But they insist that they will do this when the economy recovers.
The FED has begun this process. The press has not paid any attention to this, but the evidence is unmistakable. Any time you want to monitor any of this, search Google for "Federal Reserve charts." You can see for yourself.
First, there has been a decline of the adjusted monetary base. This began in early December. This is the major indicator of Federal Reserve policy.
Second, M1 has also fallen in recent weeks.
Third, the M1 multiplier has yet to recover.
This is the indicator that lets us know how commercial banks have responded to FED policy. This graph indicates that most bankers are still in panic mode. They prefer excess reserves at the FED at 0% to 0.25% to loans made to any borrower, including the U.S. government.
Why is the FED deflating? I offer these suggestions.
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It is testing the waters to see if unwinding will cause a crisis: a secondary recession.
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It is giving itself some wiggle room in case commercial banks begin to lend, which threatens to let M1's expansion force up consumer prices.
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It is providing visible confirmation for an announced policy that it cannot follow without creating a true depression.
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It has begun to unwind, as promised.
THE ROCK AND THE HARD PLACE
In my previous report, "Bernanke's Doom Loop," I pointed out that the Federal Reserve is trapped by the results of its own expansionary policies in 2008. The FED has more than doubled the monetary base. The big banks always evade regulation and enter into high-risk, high-return ventures, knowing that the FED and the government will bail them out.
If the FED contracts the monetary base to the mid-2008 level, there will be another collapse comparable to the September-October collapse. The FED dares not allow this.
The FED swapped its liquid Treasury assets for the illiquid toxic assets held by the big banks. There is no market for these at face value, which is why it did the swaps in the first place: to restore bank liquidity and solvency at no cost to the banks – no "haircuts," as asset discounting is called. If it sells these assets, it will take a huge loss in its balance sheet. It dares not write down that balance sheet, for the effect would be to withdraw reserves from the banking system: severe monetary deflation.
It has the same problem with its $1.2 trillion in holdings of Fannie Mae and Freddie Mac debt. A sale would force up mortgage rates, i.e., reduce the market price of all Fannie Mae and Freddie Mac debt. Meanwhile, Barney Frank has said that he thinks both outfits must be completely re-designed. Why would the investing public pay anything close to face value?
The FED can sell off liquid assets, but it has few of these remaining. It has begun to do this, however. This is why the adjusted monetary base has contracted since early December.
If the FED continues, it will run out of liquid assets, probably before summer ends. If it simply stabilizes the monetary base, this will trigger round two of the Austrian theory of the business cycle. The Austrian theory says that the central bank can restore the economy by holding short-term rates low, but the result will be bubbles.
So far, the increase in excess reserves held by commercial banks has kept the low federal funds rate from resulting in a doubling of M1, thereby creating hyperinflation. The FED has been given wiggle room by the bankers. But this means that the recovery will be underfunded by local and regional banks. The recession will reappear.
Bernanke is a Keynesian. He is also an academic. He fills his deadly dull speeches with footnotes, in good professorial style. His footnotes do not indicate a late-career interest in the writings of Ludwig von Mises. It is unlikely that he has ever read Chapter XIX of Human Action, on interest rates, or Chapter XX, on how central bank inflation artificially lowers short-term rates, thereby fostering an economic boom that cannot survive the stabilization of money. He does not believe the following:
The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system (1949 edition, p. 552).
This is what happened in December 2007. It led to the near-collapse of the big banks in October 2008. The FED then doubled the monetary base. This drove the federal funds rate almost to zero, where it remains.
The FED used credit expansion to save the banks and the newly nationalized housing mortgage market. Now the FED is giving signs of unwinding this enormous expansion. It has been saved from hyperinflation only by commercial bankers, who prefer putting over $1 trillion in excess reserves at the FED, for a paltry 0.25% or less per annum. Mises explained why in 1949: fear.
However conditions may be, it is certain that no manipulations of the banks can provide the economic system with capital goods. What is needed for a sound expansion of production is additional capital goods, not money or fiduciary media. The boom is built on the sands of banknotes and deposits. It must collapse.
The breakdown appears as soon as the banks become frightened by the accelerated pace of the boom and begin to abstain from further expansion of credit. The boom could continue only as long as the banks were ready to grant freely all those credits which business needed for the execution of its excessive projects, utterly disagreeing with the red state of the supply of factors of production and the valuations of the consumers. These illusory plans, suggested by the falsification of business calculation as brought about by the cheap money policy, can be pushed forward only if new credits can be obtained at gross market rates which are artificially lowered below the height they would reach at an unhampered loan market. It is this margin that gives them the deceptive appearance of profitability. The change in the banks' conduct does not create the crisis. It merely makes visible the havoc spread by the faults which business has committed in the boom period (p. 559).
If the FED merely stabilizes the monetary base, it will face a recurrence of the recession of 2008–9. The economy needs capital, not fiat money. Banking capital has been misallocated. Its market price was threatened with collapse in the fall of 2008 because it was no longer productive. The past year has not made this capital any less misallocated. The money expansion has merely concealed the extent of the misallocation. It has deferred the day of reckoning.
If the FED continues to unwind, it will soon hit the brick wall of its illiquid portfolio. If it attempts to sell these to the investing public, it will become clear that the FED is technically insolvent. It is allowed to play solvency games, because it is not legally required to adopt mark-to-market accounting. It can legally continue this charade of solvency only while these assets remain on its books.
THE ILLUSION OF RECOVERY
The recovery is based on the low short-term rates that FED monetary inflation has produced. Yet in recent weeks, the FED has begun to deflate. It has withdrawn liquidity from the banking system. Yet the Fed Funds rate and the 90-day T-bill rate have remained close to zero. Treasury rates across the board have not changed much in January. In fact, they have declined slightly. Why?
Investors in fixed-income securities are still willing to settle for a negative real return. Consumer prices were up, December 2008 to December 2009 by 2.7% (CPI). Investors are nevertheless willing to accept six one-hundredths of a percent on 90-day T-bills and three-tenths of a percent on one-year T-notes.
Why should we believe that these investors are fools, while stock market investors are the smartest people on the block? Fixed-income investors have done better than investors in the S&P 500 ever since March 2000. They have received a positive rate of return, just barely, after price inflation. Stock investors have suffered nominal capital losses, plus real losses as a result of price inflation of 12.4%. Their low dividends were offset by fund management fees in no-load funds and major losses of 6% or more in load funds.
The recovery is based on a hope and a prayer: hope that the Federal Reserve has restored permanent solvency to the banking system, and a prayer that the recovery will survive the FED's monetary stabilization. Chapter XX of Mises' Human Action indicates otherwise.
The FED can deflate until such time as it runs out of liquid assets. Then it will stop. It may stop before if the economy begins to reverse course visibly.
The commercial banks may decide to start lending again. If they do, the FED can raise reserve requirements. This will send a signal to the world that monetary inflation is about to make itself felt, as a result of a rise in the M1 multiplier. If the FED does this, it will send a signal to banks: there will be no recovery of bank profits, other than for the big banks. This will lead to a sell-off of regional bank shares. That will further de-capitalize the already de-capitalized banking system. It will mean the return of leverage, as I described in the doom-loop scenario.
Meanwhile, the President and Congress are incapable of doing anything significant to reduce the rate of unemployment. They know what will happen to incumbent Democrats in Congress in November if unemployment is still close to 10%. They are frantic to get the recovery translated into jobs. But the recovery is weak.
When the T-bill rate is stuck at six one-hundredths of a percent, this sends a message: either FED inflation or else the collapse of confidence in the private sector's capital markets: a flight to safety. The FED has not been inflating. It has been deflating. So, the T-bill rate tells us that those whose money is at stake are not convinced that the recovery is real. Local bankers, whose banks fund small businesses, which in turn provide most of the nation's employment, are paralyzed with fear. They are facing a decline in commercial real estate that threatens hundreds of banks – maybe a thousand – with legal insolvency if the accounting profession re-establishes and enforces mark-to-market accounting.
The economy is stalled where it matters most: job creation and business profits. Any profits are still coming mostly from cost-cutting, which means high unemployment.
CONCLUSION
The FED is caught in a trap of its own making. Bernanke cannot figure a way out of it. He promises to unwind, but this is the assurance of the alcoholic that his days of uncontrolled alcoholism are behind him.
There has been a recent period of monetary sobriety. The FED can reverse this at any time. For as long as it lasts, however, the economy will be faced with deflationary pressures. This is healthy, but not for incumbent politicians. They will demand action on the part of the FED to get the economy moving upward again. All the FED can do at that point is inflate. At some point, it will. But, for now, it has adopted a policy of preliminary unwinding.
Let us hope that this continues. But let us be realistic: it won't.
Gary North [send him mail ] is the author of Mises on Money . Visit http://www.garynorth.com . He is also the author of a free 20-volume series, An Economic Commentary on the Bible .
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