The Fed is Not Out of Ammo, but it Doesn't Matter if the Gun Blows Up In Thier Face

It is spouted all over main stream and alternative financial media, some variant of, the Federal Reserve is out of ammo. This is pure and utter nonsense and there is absolutely no evidence of the Fed being out of monetary tools.

The Fed could easily restart QE, ban cash, implement negative rates, institute helicopter money, or even the E-Dollar. There are plenty of options for the Fed to further loosen monetary policy. If these statements are made with the belief that the use of these policy tools will result in damage to the feds credibility or that there will be political pressure against such moves, watch a financial crisis to develop and see how easy it is for these tools to be deployed.

When the gun blows up in the feds face, aka market forces in the bond and currency markets dictate the feds direction, that's when the game is over and we are far from that point.

Here is an excerpt from the How They Got Us Into This Mess on how market forces can cause a policy tool misfire.



The question may be raised that if the Fed can create money out of thin air then all these numbers are bunk and don't matter so let's investigate that. It is true that the fed can create dollars, but they have to loan them into existence, and as we saw above, borrowing money cannot solve a solvency crisis.

This brings us back to outright debt monetization, granted it is illegal under current statutes. Debt monetization if done in sufficient quantities would appear to fix the problem or significantly postpone it, but how much money would they have to create? Currently, as shown in the chart below there are about 12 trillion dollars in existence going by the MZM money supply. There are different measures of the amount of dollars in existence due to the definition of a dollar being a bit hazy, MZM is sufficient for our purposes.
Source: Federal Reserve Bank of St. Louis, Velocity of M2 Money Stock [M2V], retrieved from FRED, Federal Reserve Bank of St. Louis https://research.stlouisfed.org/fred2/series/M2V

Increasing the money supply from 8 to a little over 12 trillion dollars in the past few years has been sufficient to re-inflate the housing market, push the stock and bond market to new all time highs and cause price increases in many other sectors of the economy, all this while money velocity has been dropping to an all-time low. Now imagine the fed adds enough dollars to attempt to make the US government appear solvent, and take enough of a load off the private sector to get them borrowing again, how much would it take? To monetize enough debt just to take the debt load back to where it was in 2006 we would have to monetize 10 trillion dollars' worth of debt. That's 10 trillion new dollars floating around out there. Would taking us back to the 2006 debt load be sufficient? Would we need 20 trillion (2004) or 30 trillion (2001)? Remember the amount of money in an economy doesn't necessarily cause rising prices, but it doesn't hurt.

Through QE The Fed has put a few trillion into the economy but prices have not risen as quickly due to a rapid decrease in money velocity as well as some other variables including money being sent overseas causing inflation in foreign economies. If the fed were to pump tens of trillions of dollars into the economy the necessary psychological shift to increase money velocity here at home would certainly occur and would cause massive inflation. The point at which this would happen is difficult to pinpoint but there is no doubt that this kind of money creation would cause people to lose faith in the currency. Money velocity is at a historic low but unlike the money supply there can be relatively massive changes in money velocity overnight. Every .1 tick mark on the chart on the scale below is equal to an increase of apparent money in circulation of 6%.


Source: Federal Reserve Bank of St. Louis, Velocity of M2 Money Stock [M2V], retrieved from FRED, Federal Reserve Bank of St. Louis https://research.stlouisfed.org/fred2/series/M2V

The final wall that completely boxes the fed in is their inability to fight inflation.

It has already been explained why, in 1981, the federal government was able to stop the inflation through raising interest rates. The mechanism through which inflation is stopped is simple, if an individual holding cash is experiencing 10% inflation the natural reaction would be to get rid of that money before it loses value. That is, unless they can get 12% return in a savings account. If the interest rate is above the inflation rate that individual will rationally put the money in the bank account, the bank then hands the money over to the fed at an even higher rate, the money velocity slows as the money sits in accounts at banks or at the fed, thus inflation drops. This process raises the interest rates for any entity who wants to borrow money.

One of the borrowers is the US government. In 1981 the government could handle the higher rates, but could they now? The federal government needs to roll over trillions of dollars of debt each year, meaning as the term of one bond ends they cannot pay it off and have to borrow again with a fresh bond to pay it off. For some quick and dirty numbers let's say inflation is running at 10%, and rising, and the fed raised rates to some point above that. This pushes the new rates at which the federal government borrows at to around 15%. If in that year the federal government needs to roll over 5 trillion in debt, the additional cost to service the debt would represent an increase in government expenditures of 750 billion. All new debt would also be at these higher rates, and of course additional old debt would need to be rolled over each year, further adding to debt service load. With only 2.5 trillion in annual revenue these numbers are clearly not possible. Do you remember how the media portrayed the "fiscal cliff"? Armageddon comes to mind. That was a cut of less than 100 billion a year, the cut into the federal budget that would be necessary to get high inflation under control through higher rates would be closer to a trillion dollars per year.

The recent savior and debt purchaser for the federal government has been the Federal Reserve itself, through QE, but this would not be available while fighting inflation. It would be counterproductive to fund the government with newly printed money while raising interest rates to slow money velocity, though I wouldn't be surprised if the fed did something like this in secret. Raise interest rates in public while printing and funding the government in private in hopes the reduction in money velocity would overcome the increase in money supply. That would be a last gasp of the current monetary system.

The other "tool" you may hear the fed has at its disposal to fight inflation is the virtual money incinerator. This is what the fed touts as the balance to the virtual printing press. They are virtual due to the fact that new money is created electronically thus not printed, similarly the incinerator does not literally burn money, it similarly just electronically deletes it. But though the fed does have the ability to destroy some of the money supply, to do so it must get ahold of it first.

The fed can't just take money to destroy it; it must trade for that money. What does it have to trade? Well the debt instruments it has on its balance sheet that it has acquired through QE and generating base money. The fed sells the mortgage or government bonds into the market and destroys the proceeds, "incinerating the money".

So how much money could the fed destroy thus reduce the money supply using this mechanism? To find the answer we must know how to price the bonds it has on its balance sheet.

I am going to dig into some formulas but the main takeaway is as the yield (interest paid) goes up the price goes down. If you don't feel the need to see the numbers feel free to skip the next section.

Here is the formula on how to price a bond, whether muni, federal, mortgage, or corporate.



So let's do a few of examples, one where the price of the benchmark 10 year treasury bond is around 2% similar to where the rates during much of the QE, and one during a possible future high inflation environment where the long term bond rates are similar to the rates necessary to kill inflation in the early 1980's under Paul Volker.
And finally, let's see the result if the Fed sold all of the bonds acquired at an average rate of 2.5% during QE. We'll assume $4 trillion total, and the bonds are sold at an average interest rate of 15% with an average duration of 16 years.



This is all to illustrate the fact that the fed could get 100% bang for their buck with their printing press but would only be able to reverse that to the tune of 25% using their "money incinerator" in a high rate environment. The sale of long term bonds would also exacerbate the rise in rates, more supply=lower price =higher yield/interest rate.

Consider that you have cash on hand, you are concerned about inflation and are considering purchasing a tangible good such as storable food or toilet paper for fear it will be more expensive in the future. Official inflation statistics are running at 10% but at the grocery store, week to week, it seems higher. Even the official inflation rate trend is up. How much would you be willing to pay for an investment that is going to end up paying you back in dollars IN TEN YEARS? I'm guessing your answer is very low, pennies on the dollar, if anything at all. This rational reaction may completely remove the bid for what the Fed is selling rendering the incinerator completely worthless, but even if the fed were successful in destroying a trillion dollars from the money supply, that is more than made up for by an increase in the money velocity of just 10% on the ratio in the chart above.

Also consider as a side note that the above losses represent the losses that could be incurred by long term bonds and bond funds held by a huge percentage of the population in 401k's and pensions if liquidation is necessary. Essentially when bond interest rates rise, a seller of a bond with lower coupon rate than the current rate incurs a loss commensurate with the difference between the two over the duration of the bond. This is how bonds can be traded with different coupon rates seamlessly. If a bond can be sold at a 65-80% loss why are they touted as risk free? Granted bond investors have enjoyed the mirror of this mechanism over the past thirty years as rates have fallen but one should remember the blade cuts both ways.

Our monetary system is in dire straits but to make matters worse, since the entire country is on a fiat currency system there is no gold, silver, or alternative currency in circulation to fall back. If there is massive inflation or a destruction of the money supply through deflation there is no easy answer to maintain a functioning economy. In the case of the hyperinflation in Zimbabwe a few years ago there was already a functioning economy in dollars to fall back on, no such luck in the US. If there was hyper-inflation or massive deflation I'm sure another medium of exchange would pop up, or trade could be done by barter which is currently happening in Greece, but it would be pretty ugly.


No the fed is not out of bullets, but that's not to say that they will always have the ability to deploy the policy tools they have remaining. As illustrated here much of what is now being discussed will also end in failure, but that won't prevent them from attempting to kick the can yet again.

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