April 25, 2009

"With conventional monetary policy having reached its limit, any further policy stimulus requires a different set of tools." -- Ben Bernanke, April 3.

I have this mental image of Bernanke and a dozen other Ph.D.-holding economists laboring over a car. Its hood is up. It is stalled at the side of the road. It is about an hour from Yuma, Arizona, the fan belt capital of the world. Bernanke has a tool kit next to him. It is filled with brand-new metric tools. He is working on a used Plymouth.

The problem is, the car they are working on is not their car. It's ours.

In the good old days, the FED's tool kit was simple: expand the monetary base, lower the federal funds rate at which banks lend to each other overnight, and issue a press release about the mandate for economic recovery.

It's not working any more.

THE ULTIMATE TRAP

The FED has increased the monetary base to such an extent that there is now way to turn back without risking not merely a recession, which we are in, but a depression, which the FED has inflated to avoid.

This is clear to anyone who understands the Austrian theory of the business cycle. The FED has moved into panic mode. Yet it has been unsuccessful so far in stemming the tide of recession.

The Federal deficit is now out of control. When Congress consents to a $1.8 trillion deficit, it no longer exercises the power of the purse.

The FED will have to fund whatever the private markets will not fund, which now appears to be whatever foreign investors refuse to fund. They sold a quarter of a trillion dollars in Treasury debt in February and March. These debt certificates constituted an increase in supply on the capital markets. These unexpected sales would have raised Treasury interest rates had the FED not intervened to buy more Treasury debt.

The question of questions now is this. When banks at last decide that this economy is safe enough to lend into, the excess reserves that they hold at the FED will flow into the economy. This will put the FED's balance sheet into play. The fractional reserve banking process will take over. M1 will increase by 100%. It will not be offset by a decline in the M1 money multiplier.

The fun will begin.

Bernanke understands this. He knows what will happen to the money supply unless the FED increases reserve requirements to offset the increase in the monetary base. The FED can do this, of course. But then it is back to square 1: the recession that its increased spending will have overcome will return.

He is in a lobster trap. He says he can get out.

He said in his April 3 speech that this will not be a pressing problem anytime soon. This was another way of saying that bankers will remain too terrified of this economy to lend.

At its December 2008 meeting, the Federal Open Market Committee (FOMC) reduced its target for the federal funds rate close to its lower bound, setting a target range between 0 and 1/4 percent. And, with inflation expected to remain subdued for some time, the Committee has indicated that short-term interest rates are likely to remain low for an extended period. With conventional monetary policy having reached its limit, any further policy stimulus requires a different set of tools.

"Tools." He has begun to use this word again and again in his speeches. He makes monetary policy look like a candidate for one of those auto manuals that Chilton publishes.

The Federal Reserve has been a global leader in developing such tools. In particular, to further improve the functioning of credit markets and provide additional support to the economy, the Fed has established and expanded a number of liquidity programs and recently initiated a large-scale program of asset purchases. These actions have had significant effects on both the size and composition of the Federal Reserve's balance sheet. Notably, the balance sheet has more than doubled, from roughly $870 billion before the crisis to roughly $2 trillion now.

Depository institutions also maintain accounts at the Federal Reserve, of course, and over recent months, as the size of the Federal Reserve's balance sheet has expanded, the balances held in these accounts have increased substantially.

Translation: "Bankers are scared out of their wits. They know this economy is close to going over the edge. They would rather get paid nothing on deposits at the FED than lend money. They think they will lose money in today's economic environment."

The large volume of reserve balances outstanding must be monitored carefully, as -- if not carefully managed -- they could complicate the Fed's task of raising short-term interest rates when the economy begins to recover or if inflation expectations were to begin to move higher.

Translation: "When the huge increase in FED reserves finally starts pushing up prices, bankers' decision to lend money will push prices up even higher. Rates will climb, so bankers will lend more, and prices will climb. In short, what the FED has already done will finally create conditions of mass price inflation: price increases well into double-digit rates."

MAGICAL TOOLS

Bernanke assured his listeners that the FED has lots of ways to deal with this threat -- painless, politically acceptable ways, he implied.

We have a number of tools we can use to reduce bank reserves or increase short-term interest rates when that becomes necessary. First, many of our lending programs extend credit primarily on a short-term basis and thus could be wound down relatively quickly. In addition, since the lending rates in these programs are typically set above the rates that prevail in normal market conditions, borrower demand for these facilities should wane as conditions improve.

Translation: "The money we have created to bail out the financial system will return to the FED and be mopped up. It will not be lent out again." The word "many" means "we aren't saying how much, and we will not tell you if you ask."

Second, the Federal Reserve can conduct reverse repurchase agreements against its long-term securities holdings to drain bank reserves or, if necessary, it could choose to sell some of its securities. Of course, for any given level of the federal funds rate, an unwinding of lending facilities or a sale of securities would constitute a de facto tightening of policy, and so would have to be carefully considered in that light by the FOMC.

Translation: "The FED can adopt a policy of monetary deflation for as long as it takes to revert back to the monetary base that prevailed in . . . we aren't saying." The FED will deflate. We will enter the Twilight Zone.

Third, some reserves can be soaked up by the Treasury's Supplementary Financing Program.

Translation: "The Treasury, which will run a $1.8 trillion deficit in 2010, will somehow come up with enough money -- not from the FED -- to buy back these loans. I am not at liberty to say how the Treasury will accomplish this. Trust me."

Fourth, in October of last year, the Federal Reserve received long-sought authority to pay interest on the reserve balances of depository institutions. Raising the interest rate paid on reserves will encourage depository institutions to hold reserves with the Fed, rather than lending them into the federal funds market at a rate below the rate paid on reserves. Thus, the interest rate paid on reserves will tend to set a floor on the federal funds rate.

Translation: "The floor is now at 0%. The depository institutions are holding money at the FED. Raising interest rates on excess reserves will keep them from lending to the general public. This has the same effect as raising the reserve requirement. This means that money will not get into the economy." Then what happens to the recession? It will return, along with its cousin, depression.

The FOMC will continue to closely monitor the level and projected expansion of bank reserves to ensure that -- as noted in the joint Federal Reserve-Treasury statement --the Fed's efforts to improve the workings of credit markets do not interfere with the independent conduct of monetary policy in the pursuit of its dual mandate of ensuring maximum employment and price stability.

Translation: "The FED has not stabilized prices since 1955. That is a given. So, ensuring maximum employment is the FED's problem. Unemployment rises every month. We are inflating like mad, yet the recession is getting worse." Problem: The FOMC can monitor all it wants to. The FED's policy of mass monetary inflation is not working. If the FED tries to keep banks from lending in the recovery phase, the recovery will revert to recession. If it maintains this policy, depression will replace recession.

KOHN CHIMES IN

The number-two member of the Board of Governors, Donald Kohn, spoke on April 18 in Nashville: "Monetary Policy in the Financial Crisis."

He warned that the loans the FED has made will not be repaid anytime soon. They are near-permanent components of the FED's balance sheet, i.e., the monetary base.

However, our newly purchased Treasury securities and MBS will not mature or be repaid for many years; the loans we are making to back the securitization market are for three years, and their nonrecourse feature could leave us with assets thereafter.

What can the FED to do reverse the expansion of M1 that the monetary base has authorized banks to create through making loans?

But we have a number of tools we can use to absorb the resulting reserves and raise interest rates when the time comes.

There is is again: "Tools."

We can sell the Treasury and agency debt either on an outright basis or temporarily through reverse repurchase agreements, and we are developing the capability to do the same with MBS.

Kohn, unlike Bernanke, does not need a translator. Problem: The FED had to buy Treasury debt in order to fund the deficit. It has exchanged half of its Treasury debt for toxic assets at face value. If it hadn't, the banks would have collapsed. There is not much Treasury debt left to sell. As for agency debt, this means Freddie and Fannie, which were nationalized. Nobody will lend a dime on these assets at face value. As for "repurchase agreements," they mean that the FED will have to buy them back with newly created fiat money. Hello, inflation.

Finally, we are working with the Treasury to promote legislation that would further enhance our toolkit for absorbing reserves.

What does this mean? He refused to say. Absorbing reserves means selling off assets. To whom? At what interest rate? With what guarantees? Silence.

Already the FOMC has extended its forecast horizon to indicate where the Governors and Reserve Bank presidents would like to see inflation coming to rest over time.

Somewhere, over the rainbow, way up high.

And we are continuing to discuss within the Committee whether an explicit numerical objective for inflation would be beneficial.

You can sense the terror at the FED. They may set actual price index targets. He did not mention the possibility of making these targets public knowledge.

Under current circumstances, those benefits would include underscoring our understanding that our legislative mandate for promoting price stability encompasses both preventing inflation from falling too low in the near term and from rising too far as the economy recovers.

We have heard this before. It is the story of three bears and a girl who breaks into the bears' house and tastes two bowls of porridge and eats the third.

The Federal Reserve's actions over the past 20 months have been consistent with the principles of central banking that have been developed over the course of centuries.

True. The FED intervened to save the big banks and the investment banks. That is what central banks have done for centuries.

But the greatly increased complexity of our financial institutions and markets, as well as the virulence of the financial crisis in choking off the flow of credit through a broad range of channels, has meant that in applying these principles, the Federal Reserve and other central banks have had to extend their reach and adopt new measures to preserve financial stability and to counter the effects of financial turmoil on the economy. In my view, these actions have been necessary, safe, and effective and will not lead to adverse aftereffects.

It is one thing to have a goal. It is something else to have a program that will achieve it. He offered no idea of how the banks can achieve it. We know only this: nothing is working so far.

Two days later, he gave another speech. It was a masterful presentation of what Harry Truman called the two-armed economist. Harry asked to talk with a one-armed economist.

On the one hand, we cannot rule out the possibility that adverse economic conditions will cause deeper cuts in prices, a greater softening in wages, and a steep decline in inflation expectations. Substantial declines in inflation would raise real interest rates, thereby restraining the recovery even more. Moreover, the risk that inflation could be lower will be exacerbated to the extent that economic activity falls short of the path that I have described. In these circumstances, the Federal Reserve would continue to look for ways to relieve financial pressures and encourage spending.

This is what the FED has been facing. Banks are parking their money in the equivalent of Yuma. They are not lending. The recession is accelerating.

On the other hand, the Federal Reserve's actions to ease credit conditions have resulted in a tremendous increase in its assets and in bank reserves. Some observers have expressed concern that these actions, if not reversed in a timely manner, are sowing the seeds of a sharp pickup in inflation down the road.

Some observers have the ability to read the FED's balance sheet or understand a graph that is going straight up: the adjusted monetary base. They see what is about to happen: mass inflation.

As I just noted, near-term prospects appear to be for a decline in inflation rather than an increase. But my colleagues and I are acutely aware of the risk of higher inflation as the economic recovery gains speed. We are firmly committed to acting in a way that preserves price stability, and we believe we have the tools to absorb reserves and raise interest rates when needed. Moreover, we are working with the Treasury to introduce legislation that would enlarge our tool kit for moving away from the extraordinary degree of financial stimulus we have put in place when the time arrives.

This man has great faith in new tools. These tools, whatever they are, have never been tried. Meanwhile, the international economy is headed lower.

CONCLUSION

Bernanke and Kohn assured their listeners that these tools will save the day. Economic cause and effect will be overcome. There will be a widespread recovery without price inflation. The FOMC will monitor this. The Treasury will authorize a new bag of tools for the FED to use.

Specifics? Nothing that isn't preposterous, such as selling toxic assets back to the banks at face value, or even less likely, selling them to investors at face value.

The FED can always sell Treasury debt, we are told. The Treasury will then sell its debt at low, low rates to domestic investors who will decide to buy Treasury debt -- a defensive investment -- instead of stocks, commodities, and corporate bonds during a recovery.

None of this makes sense to me. But, then again, I am not a Keynesian. I am the author of The Gold Wars.