Tag Archive for: FederalReserve

Fed’s Favored Core PCE Price Index Re-Accelerates, Driven by Services, Motor Vehicles: Inflation Stuck on High, Shifts from Item to Item

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Estimated Reading Time: 2 minutes

Not encouraging: core PCE price index refuses to come down, and has moved sideways since July last year.

The inflation index favored by the Fed, the core PCE price index – which, by excluding the food and energy products, is a measure of underlying inflation – re-accelerated in April, as services inflation re-accelerated back into the red-hot zone, and as durable goods prices rose, after falling for months, driven by a jump in motor vehicles and parts.

Inflation is just churning from one product category to another, falling here but popping up again over there like the arcade game of Whack A Mole. And so the core PCE price index continues to be stuck near the 5% level when the Fed’s target is 2%. And the Fed uses this core PCE index as yardstick.

On a year-over-year basis, the core PCE price index jumped by 4.7%, same as in July 2022, and up from a 4.6% increase in March, according to data from the Bureau of Economic Analysis today. It has now gone sideways at just under 5% for nearly a year, and is not coming down, but is only shifting from category to category.

Inflation in services re-accelerated in April from March, driven by spikes in insurance and financial services, and “other” services such as personal services, and big increases in healthcare and housing costs.

Inflation is particularly difficult to wring out of services, but services are where the majority of consumer spending ends up: healthcare, housing, utilities, education, travel, entertainment, restaurant meals, streaming, subscriptions, broadband, cellphone services, etc…..

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Continue reading this article at Wolf Street.

What’s Next for the Fed?

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Estimated Reading Time: 3 minutes

After neglecting to address inflation throughout 2021 and into 2022, the Federal Reserve has now raised its interest rate targets 10 consecutive times, to the highest level since 2007.

At his press conference to announce the change, Fed Chair Jerome Powell emphasized the Fed’s priority of reducing inflation and stressed that the Fed will maintain high interest rates as long as is needed to achieve this goal.

Given the turmoil in the banking system and softening of the labor market, is the Fed likely to fulfill this commitment? What factors might cause the Fed to revise its monetary policy?

Will interest rates remain elevated? Powell has repeatedly stated that the Federal Open Market Committee (FOMC), which determines the stance of monetary policy, has no plans to cut interest rates in the current year. Several FOMC members, however, have expressed views that the committee should pause its rate hikes for now to evaluate the effects of its recent policy changes.

While not committing to a pause, Powell pointed out the FOMC had removed from its new monetary policy statement a note in previous statements that “some additional policy firming may be appropriate.”

One reason for Powell’s emphasis on keeping interest rates high is his fear that if the public believes the Fed will cut rates, then they will expect more inflation, and that change in expectations could actually cause inflation to rise. The FOMC must signal that they are willing to keep rates high since their priority, at least for now, is to stamp out inflation.

What are market participants expecting? Despite Powell’s insistence that the Fed has no plans to reduce its interest rate targets, it appears that financial market participants do not believe him. Financial markets indicate that the Fed is expected to stabilize interest rates through the summer and begin cutting in the fall. This might happen for one of two reasons.

First, the Fed’s ideal scenario is that inflation continues to slow, in which case, they could reduce interest rates slightly to what they consider to be the “normal” range with little negative side effects to the economy. Falling inflation implies an increase in real interest rates, so the FOMC may need to reduce interest rates in order to maintain a neutral policy rather than becoming overly restrictive.

Second, most economists are predicting a recession this year. If it happens soon, the Fed will be stuck with two bad options: either keep interest rates high to prevent inflation or cut interest rates to address the recession. Given the Fed’s history and Powell’s past reluctance to address inflation, the markets may be betting on the latter.

What will determine the Fed’s decisions? Chair Powell said that, going forward, the Fed will be data dependent in its monetary policy decisions. Three important factors they will likely consider are inflation, unemployment, and the prospect of further bank failures.

The Fed is hoping inflation, and especially inflation expectations, will continue to fall. High inflation has been harmful to average Americans, and getting it down has become the Fed’s top priority. Falling inflation would give the Fed more room to cut rates without pushing up expectations.

Employment remains strong but may be slowing slightly, which is fine since the Fed wants it to calm to a sustainable pace. If unemployment rises substantially, indicating a likely recession, it is not clear how the Fed will respond, especially if inflation remains high.

Despite the negative effects of high interest rates on the banking sector, the Fed is reluctant to lower rates for fears of perpetuating inflation. It has sought to address banking problems with emergency lending facilities rather than through monetary policy. That has worked so far. If more bank failures threaten the financial system or put the economy at risk of recession, however, the Fed may choose to reverse course and lower interest rates to address these issues.

The economy is stable for now with low unemployment, falling inflation, and interest rates expected to remain stable, at least for a while. A wide range of outcomes are still possible for 2023, ranging from stagflation to a “soft landing.” The Fed’s response to economic conditions in the coming months may tell us which of those outcomes is most likely.

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This article was published by the AIER, American Institute for Economic Research and is reproduced with permission.

Crowding Out: The Fed May Be Killing the Private Sector to Save the Government

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Estimated Reading Time: 2 minutes

The Federal Reserve’s balance sheet reached its all-time high in May 2022. Since then, it was supposed to drop at a steady pace and shed three trillion US dollars by 2024. The normalization of monetary policy was built on the idea of a soft landing for the economy. However, the Fed may be killing the private sector to save the government.

Curbing inflation requires a significant reduction in the money supply and aggregate demand. However, if government deficit spending is left untouched, the entire burden of normalizing monetary policy will fall on families and businesses.

The current situation is the worst possible. The Fed’s balance sheet is not falling as fast as it should; government spending has not even been scratched, but the money supply is falling at the fastest pace since the 1930s, and rate hikes are hurting the productive economy while the government seems unaware of the need to reduce its bloated budget.

The first-quarter GDP figure is extremely concerning. Government spending showed yet another big rise at +4.7 percent, much higher than expected. However, consumption, at +3.7 percent annualized, was well below estimates and driven by a worrying new record in credit card debt. Even more concerning, gross private domestic investment fell by a massive 12.5 percent.

There is robust evidence of a negative trend in the real economy. Rising federal expenditure, more bureaucracy, higher taxes, and weaker activity in the part of the economy that drives growth and jobs.

Rate hikes have two direct negative effects on the economy if the government does not reduce its deficit spending spree. They mean higher taxes and a massive crowding out of available credit. The government deficit is always going to be financed, even if it is at higher rates, but this also means less credit for businesses and families. The crowding-out effect of the public sector over the productive economy means lower productivity growth, weaker investment, and declining real wages as the government keeps inflation above target by spending additional units of newly created currency, but the productive sectors find it harder and more expensive to find credit. Additionally, the government borrows at a much lower cost than even the most efficient and profitable businesses.

It is impossible to achieve a soft landing for the economy when the Federal Reserve ignores the signals of the banking system and the real economy. The first pillar of a true soft landing must be to preserve the real disposable income of workers and the job creation and investment capabilities of businesses.

When the government continues to increase spending, there is no signal of the mildest budgetary control, and the entire “landing” comes from the private sector, what we get is upside-down economics.

The Federal Reserve has stopped paying attention to monetary aggregates just as the money supply is contracting at an almost historic pace. Even worse, the money supply is contracting but federal deficit spending is untouched, and the debt ceiling was raised again.

The money supply is collapsing due to the inevitable credit crunch and the difficulties faced by consumers and businesses. It is impossible to grow with rising taxes, persistent inflation—a tax in itself—and carrying the entire burden of the normalization of monetary policy.

Fighting inflation without cutting government spending is like dieting without eliminating fattening foods.

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This article was published by the Ludwig von Mises Institute and is reproduced with permission.

A New Fed Report Holds a Clue on Why Banks Are Collapsing

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Estimated Reading Time: 3 minutes

Federal regulators seized the struggling First Republic Bank on Monday [5/1/23], which they promptly sold to JPMorgan Chase. Reports show First Republic had some $230 billion in financial assets which quickly evaporated, making it the second largest bank collapse in US history, exceeding the recent bankruptcies of Silicon Valley Bank and Signature Bank.

You read that correctly—three of the four largest bank collapses in US history have occurred in the last 60 days. The events naturally have raised questions about the strength and durability of the US banking system. As of Tuesday, confidence appeared weak. The KBW Regional Banking Index saw shares hit an annual low as investors fled from regional bank stocks.

That something is wrong in the US financial sector is apparent, but few agree on the source of the affliction. Some blame banks for going “woke”, while others point to Federal Reserve policies. Others call out the failure of regulators and bank auditors.

One possible cause for the financial reckoning has gone largely unnoticed, though it was buried in a Federal Reserve report published Friday.

While the conventional wisdom is that banks simply need to be regulated harder, a report from the Fed’s board of governors suggests banks are already struggling to navigate a labyrinth of federal rules and regulations. This was particularly true of SVB, which had experienced rapid growth in recent years, causing it to “move across categories of the Federal Reserve’s regulatory framework.”

That framework, the Fed dryly notes, “is quite complicated.” (Indeed.) And the report makes it clear that SVB was spending a lot of time and money on consultants trying to navigate this framework “to understand the rules and when they apply, including the implications of different evaluation criteria, historical and prospective transition periods, cliff effects, and complicated definitions.”

Ultimately, the Fed points the finger squarely at SVB in its postmortem, not government regulations.

“Silicon Valley Bank’s board of directors and management failed to manage their risks,” the report states. “Supervisors did not fully appreciate the extent of the vulnerabilities as Silicon Valley Bank grew in size and complexity.”

That SVB bears the most blame for its demise is true, as I’ve explained. But the Fed’s report sheds new light on why SVB wasn’t as focused on managing its risk as it should have been.

“It’s clear SVB found it challenging to deal with an overly complicated regulatory framework being pushed by the Fed, which included a new focus on climate change risk assessment and cultural issues, such as fairness and equity,” Stephen Dewwey, a retired federal financial regulator, tells me. “That is time and resources the bank could have spent analyzing interest rate risk and prudent management of its balance sheet.”

Although the Fed owns up to some of its own regulatory impotence during the collapse, it mostly passes the buck onto SVB. Worse, the central bank cites SVB’s collapse as a reason to give regulators more control over the financial system. This might sound ludicrous given the Fed’s recent failures, yet it’s precisely what we should expect.

“An iron law of the modern administrative state is that the solution to regulatory failure is always to give regulators more power,” the Wall Street Journal’s editorial page noted.

This phenomenon is what Austrian economist Ludwig von Mises described in his historic 1950 address “Middle-of-the-Road Policy Leads to Socialism.” Mises understood that not all countries adopt socialism through bloody revolutions. Some arrive there slowly, through a process he describes as “interventionism,” which is viewed as a middle way between “unbridled capitalism” and socialism.

The problem is, these interventions—price controls, labor standards, consumer protections, etc.—come with costs and often create market problems. When these problems arise, regulations rarely are lifted. On the contrary, the “free market” is often blamed, and more intervention is demanded.

“As a remedy for the undesirable effects of interventionism they ask for still more interventionism,” Mises observed. “They blame capitalism for the effects of the actions of governments which pursue an anti-capitalistic policy.”

This is precisely what is happening today with the banking crisis. Instead of blaming the government’s byzantine regulatory framework or the Fed’s monetary schemes—which no doubt are even more to blame—bureaucrats say they simply need more control.

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This article was published by FEE, Foundation for Economic Education and is reproduced with permission.

A Frightening Solution to the Debt Ceiling Crunch

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Estimated Reading Time: 7 minutes

Much has been written about the Congressional debt-ceiling standoff. US Treasury and Federal Reserve Board officials have insisted that the only way to prevent a federal government default on its debt is for Congress to simply raise the debt ceiling without requiring any reduction in spending and deficits.

However, more imaginative measures could be taken to forestall a general federal government default without increasing the debt ceiling. For example, we have previously shown that legislation that increases the statutory price of the US Treasury’s gold holdings from its absurdly low price of $42.22 per ounce to something close to gold’s $2000 per ounce market value provides an efficient process—one historically used by the Eisenhower administration—to significantly increase the Treasury’s cash balances and avoid default while budgetary debate continues.

In this note, we explore, as a thought experiment, the possibility that the cancellation of up to $2.6 trillion of the $5.3 trillion in Treasury debt owned by the Federal Reserve System could be used to avert a federal government default without any increase in the debt ceiling. We suggest that, given the enforcement of current law, federal budget rules, and Federal Reserve practices, such an extraordinary measure not only would be permissible, but it could be used to entirely circumvent the Congressional debt ceiling.

The Federal Reserve System owns $5.3 trillion in US Treasury securities, or about 17% of the $31 trillion of Treasury debt outstanding. The Fed uses about $2.7 trillion of these securities in its reverse repurchase agreement operations, leaving the Fed with about $2.6 trillion of unencumbered US Treasury securities in its portfolio.

What would happen if the Fed “voluntarily” released the Treasury from its payment obligations on some of all of the unencumbered US Treasury securities held in the Fed’s portfolio, by forgiving the debt? We believe there is nothing in Constitution or the Federal Reserve Act that would prohibit the Fed from taking such an action. This would free up trillions in new deficit financing capacity for the US Treasury without creating any operating difficulties for the Federal Reserve.

There is a longstanding debate among legal scholars as to whether the Fourteenth Amendment to the Constitution makes it unconstitutional for the federal government to default on its debt. But voluntary debt forgiveness by the creditor on the securities owned by the Federal Reserve would not constitute a default and the arguments related to the Fourteenth Amendment would not be applicable.

The Federal Reserve System is an integral part of the federal government, which makes such debt forgiveness a transaction internal to the consolidated government. However, the stock of the twelve Federal Reserve district banks is owned by their member commercial banks. Would it create losses for the Fed’s stockholders if the Fed absolved the US Treasury of its responsibility to make all payments on the US Treasury securities held by the Fed? We don’t think so.

The Fed has already ignored explicit passages of the Federal Reserve Act that require member banks to share in the losses incurred by their district Federal Reserve banks. Under its current operating policies, the Fed would continue to pay member banks dividends and interest on member bank reserve balances even if the entire $2.6 trillion in unencumbered Treasury debt securities owned by the Federal Reserve System were written off. Such a write-off would make the true capital of the Federal Reserve System negative $2.6 trillion instead of the negative $8 billion it is as of April 20.

The Federal Reserve Act requires member banks to subscribe to shares in their Federal Reserve district bank, but member banks need only buy half the shares they have pledged to purchase. The Federal Reserve Act stipulates that the “remaining half of the subscription shall be subject to call by the Board.” At that point, the member banks would have to buy the other half. Presumably, the Fed’s founders believed that such a call would be forthcoming if a Federal Reserve Bank suffered large losses which eroded its capital.

In addition, Section 2 of the Act [12 USC 502] requires that member banks be assessed for district bank losses up to twice the par value of their Federal Reserve district bank stock subscription.

The shareholders of every Federal reserve bank shall be held individually responsible, equally and ratably, and not one for another, for all contracts, debts, and engagements of such bank to the extent of the amount subscriptions to such stock at the par value thereof in addition to the amount subscribed, whether such subscriptions have been paid up in whole or in part under the provisions of this Act. (bold italics added)

To summarize, Fed member banks are theoretically required to buy more stock in a losing Federal Reserve district bank and to be assessed to offset some of the Reserve Bank’s losses. However, these provisions of the Federal Reserve Act have never been exercised and are certainly not being exercised today, in spite of the fact that the Fed’s accumulated losses are now greater than its capital. Indeed, the Fed consistently asserts that it is no problem for it to run with negative capital however large that capital shortfall may become.

Historically, all Fed member banks were entitled to receive a 6 percent cumulative dividend on the par value of their paid-in shares. Subsequently, Congress reduced the dividend rate for large banks to the lesser of “the high yield of the 10-year Treasury note auctioned at the last auction” (currently 3.46%), but maintained the 6% for all others. The Fed is now posting large operating losses but is still paying dividends to all the member banks. We confidently predict it will continue to do so.

Unlike normal shareholders, member banks are not entitled to receive any of their Federal Reserve district bank’s profits beyond their statutory dividend payment. The legal requirements and Federal Reserve Board policies governing the distribution of any Federal Reserve System earnings in excess of its dividend and operating costs have changed many times since 1913, but today, the Fed is required by law to remit basically all positive operating earnings after dividends to the US Treasury—but now there aren’t any operating earnings to remit.

Let’s hope Congress closes this potentially massive budgetary loophole while the idea of the Fed’s forgiving Treasury debt remains just a thought experiment.

Beginning in mid-September 2022, the Federal Reserve started posting cash losses. Through April 20, 2023, the Fed has accumulated an unprecedented $50 billion in operating losses. In the first 3 months of 2023, the Fed’s monthly cash losses averaged $8.7 billion. Notwithstanding these losses, the Fed continues to operate as though it has positive operating earnings with two important differences—it borrows to cover its operating costs, and it has stopped making any remittances to the US Treasury.

The Fed funds its operating loss cash shortfall by: (1) printing paper Federal Reserve Notes; or (2) by borrowing reserves from banks and other financial institutions through its deposits and reverse repurchase program. The Fed’s ability to print paper currency to cover its losses is limited by the public’s demand for Federal Reserve Notes. The Fed borrows most of the funds it needs by paying an interest rate 4.90 percent on deposit balances and 4.80 percent on the balances borrowed using reverse repurchase agreements. These rates far exceed the yield on the Fed’s investments.

In spite of its losses, the Fed continues to pay member banks both dividends on their shares and interest on their reserve deposits. The Fed has not exercised its power to call the second half of member banks’ stock subscriptions nor has it required member banks to share in the Fed’s operating losses.

Instead of assessing its member banks to raise new capital, the Fed uses nonstandard, “creative” accounting to obscure the fact that it’s accumulating operating losses that have rendered it technically insolvent.

Under current Fed accounting policies, its operating losses accumulate in a so-called “deferred asset” account on its balance sheet, instead of being shown as what they really are: negative retained earnings that reduce dollar-for-dollar the Fed’s capital. The Fed books its losses as an intangible “asset” and continues to show it has $42 billion in capital. While this treatment of Federal Reserve System losses is clearly inconsistent with generally accepted accounting standards, and seemingly inconsistent with the Federal Reserve Act’s treatment of Federal Reserve losses, Congress has done nothing to stop the Fed from utilizing these accounting hijinks, which the Fed could also use to cancel the Treasury’s debt.

Under these Fed operating policies, if all of the unencumbered Treasury securities owned by the Fed were forgiven and written off, the Fed would immediately lose $2.6 trillion. It would add that amount to its “deferred asset” account. Because the Fed would no longer receive interest on $2.6 trillion in Treasury securities, its monthly operating losses would balloon from $8.7 billion to about $13 billion, for an annual loss of about $156 billion. Those losses would also go to the “deferred asset” account. Treasury debt forgiveness would delay by decades the date on which the Fed would resume making any remittances to the US Treasury, but by creating $2.6 trillion in de facto negative capital, the Fed would allow the Treasury to issue $2.6 trillion in new debt securities to keep on funding federal budget deficits.

Under the federal budgetary accounting rules, the Fed’s deferred asset account balances and its operating losses do not count as expenditures in federal budget deficit calculations, nor do the Fed’s borrowings to fund its operations count against the Congressionally imposed debt ceiling. So in short, the Fed offers a way to evade the debt ceiling.

In reality, of course, the debt of the consolidated government would not be reduced by the Fed’s forgiveness of Treasury debt. This is because the $2.6 trillion the Fed borrowed (in the form of bank reserves and reverse repurchase agreement loans) to buy the Treasury securities it forgives would continue to be liabilities of the Federal Reserve System it must pay. The Fed would have $2.6 trillion more liabilities than tangible assets, and these Fed liabilities are real debt of the consolidated federal government. But in accounting, the Fed’s liabilities are uncounted on the Treasury’s books. Under current rules, there appears to be no limit to the possibility of using the Fed to expand government debt past the debt ceiling.

In other words, the Fed’s write-off of Treasury securities and its ongoing losses could accumulate into a massive amount of uncounted federal government debt to finance deficit spending. A potential loophole of trillions of dollars around the Congressional debt limit is an astonishing thought, even by the standards of our current federal government. Let’s hope Congress closes this potentially massive budgetary loophole while the idea of the Fed’s forgiving Treasury debt remains just a thought experiment.

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This article was published by Law and Liberty and is reproduced with permission.

The Next Two FED Meetings Could Be Market Movers

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Estimated Reading Time: 4 minutes

There is little doubt today that what the Federal Reserve decides to do with both interest rates and its massive balance sheet is perhaps the most important variable moving markets.  The next two FED meetings loom as particularly important.  The key dates will be May 3rd-4th and June 14th-15th.

To be sure, corporate earnings, retail sales, real estate activity, industrial production, the world economy, politics, tax policy, and numerous other variables impact markets as well.  But nothing has been moving markets over the past 20 years quite like FED policy.

While economists and historians will no doubt continue to debate the efficacy of the central bank intervention, the fact is those of us with money in markets must deal with it.

Right now, we notice the chart action of many important markets are sitting on major inflection points.  An inflection point is defined as a market at either important overhead resistance or downside support.  Which way the FED goes could well push markets above resistance or below support, creating important signals in a variety of markets.

In the past month or so, the markets have been coming down in volatility into a kind of an eerie holding pattern, suggesting considerable confusion among market participants.

The stock market has been buoyant, recovering rather quickly from some staggeringly large bank failures. The stock market seems to be saying the nirvana of the soft landing is nearby and that the FED is likely done raising interest rates. 

The stock market seems to feel the FED has taken enough inflation out of the system, that the numbers are running in the right direction, and that they will as a result, will stop raising rates (pause), and then soon shift back to lower interest rate policy.

The FED itself has been saying otherwise, but the stock market seems to be saying, you are mostly talk and you will not push the economy to recession to fight inflation…  not with a major political cycle just ahead.

The stock market does also not seem particularly concerned with earnings reports or lofty valuations.  Some of the most expensive companies, many in technology, have taken over market leadership again.

But the bond market has been strong (lower rates) but recently started to reverse trend suggesting that the FED will continue to raise interest rates.  Not only is money again becoming more expensive, evidence suggests banks and other lenders are tightening up credit requirements after the surprise of large bank failures.  Not only is credit getting more expensive, it is getting harder to obtain.  Both developments are negative for the economy and hence indirectly negative for stocks.

One of the deans of technical analysis, the late Richard Russell, used to say that when the stock market and the bond market are discounting different scenarios, Russell advised one should believe the bond market.  His reasoning was that the bond market is by comparison much larger and is mostly a professional market.  The public may dabble in stock speculation, but professionals run the bond market.

If this observation holds, be prepared for the FED to raise rates one or two more times, creating the real risk of recession.  This will wind up being positive for bonds later, but negative for stocks in the near term.

Chart courtesy of stockcharts.com

Here we see the very important 30-year mortgage rate.  It has gone up a lot and is still double what it was just at the beginning of 2022.  This has put downward pressure on housing activity since the down payment is very much a function of both the house price and the cost of interest.  But like the bond market, recently rates have started back upward, suggesting the FED is not yet done raising rates.

Other markets as well are trying to peer into the future and divine what the economy and the FED are going to do. As mentioned, many of these markets are also at important inflection points.

The gold market has moved nicely to levels above $2,000 per ounce and will either break out, or once again, fail to move higher.  Has gold stalled out or is it just gathering strength for a push to all time new highs?

Silver has moved up to a long term trendline formed by the peak in prices at near $50 per ounce a number of years ago.  It too could either break out or fail.

The US dollar has formed a large head a shoulder looking pattern with important downside support at 100 on the US dollar index.  It either holds, or it folds.  A weaker dollar suggests lower interest rates, while a stronger dollar suggests the opposite.

Chart courtesy of stockcharts.com

Two of the more interesting charts are copper and lumber, both sensitive to economic growth.

Chart courtesy of stockcharts.com

Copper has been in downtrend for more than a year.  It will either continue to fall, or gain enough strength to reverse its bear trend.  The weakness is somewhat surprising given the widespread belief in the future of electric vehicles and the need to re-tool the entire electrical grid.  Why the weakness?  Maybe copper is telling us the economy is slowing, which would not be good for the stock market. It seems to agree more with the bond market than the stock market.

Chart courtesy of stockcharts.com

Lumber prices are a key indicator of demand for housing construction and it too has been in a bear trend.  But like copper, it would not take much upside action to reverse trend.  But again, right now, lumber seems to be saying demand is soft and so is the economy.

We have real issues with the FED.  Central planning has a terrible track record as bureaucrats, absent real world free markets, can’t really know what the “proper” interest rate should be or the supply of money.

The FED largely controls the demand side of the ledger by creating money, or claims on goods.  But the FED itself can’t produce the goods, the commodities, or the structures they are creating demand for.  Hence, even if they are the best guessers in the world, they only have half the equation.

Despite what the FED likes to say, they are also a highly political organization.  Afterall, most of the governors voting on policy are nominated by the President and hence, have either loyalty to the abstraction of neutrality or reality of politics.  And guess what, we are getting very near to the next political cycle.

Inducing a recession would be highly unpopular.

But letting inflation run longer and hotter would also politically problematical.

The FED now has the markets trained to react to every decision and every rhetorical nuance.

They are now a little like the dog that finally caught the car.  Having been successful, now what does the dog want to do?

What Would Happen if the Fed Caves to 4%-5% Core PCE Inflation, Gives up on 2%, as some Folks are Clamoring For?

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Estimated Reading Time: 3 minutes

The economy would muddle through, but in the markets, all heck would break loose. Here’s why.

The issue is this: Since April 2022, the Fed has hiked its policy interest rates by 450 basis points, but consumer price inflation as measured by the “core” PCE price index – which excludes volatile food and energy products – has been moving up and down in the same high range without much visible improvement.

The core PCE price index, the Fed’s favored inflation index for its 2% inflation target, was at 4.6% in February, according to the latest release, roughly the same as in July 2022. “Core” CPI, which has been running at about 5.5% for months, actually accelerated in March.

So now there are voices – voices with big megaphones – that say that the Fed will and should change its inflation target because this inflation will not go back to 2% without a lot of economic damage, and to get that kind of economic damage, interest rates would have to rise much further, and neither the Fed nor the White House nor Congress is willing to go there.

Americans can live with 4% to 5% core PCE inflation just fine, they say. And once everyone gets used to it, it’ll vanish off the headlines, they say.

Oh really? What does acceptance of 4%-5% inflation mean for yields and asset prices? We probably don’t want to find out.

But let’s play along with it for a moment to see where this will go. Let’s assume that the Fed will actually do this, that it will say, ok, fine with us, we went as far as we’re going to go with interest rates, and 4% to 5% core PCE inflation is acceptable even over the longer term, and we’ll just closely monitor how this develops, etc. etc.

It would completely annihilate the current dream that inflation will revert to 2% by the end of 2023, or at the latest by the end of 2024.

Short-term rates are going to stay high for a long time. At 4% to 5% core PCE inflation, the Fed won’t cut short-term rates by much if at all, even if it accepts this high inflation as the new normal.

Long-term yields will explode. Long-term yields are what really matter for asset prices. They are a bet on long-term inflation. This dream of inflation reverting to 2% in short order is part of what keeps long-term Treasury yields so low. The 10-year Treasury yield is currently at about 3.5%, well below the rate of inflation. Investors buying a 10-year maturity at 3.5% are confidently betting that inflation will revert to 2% shortly.

And if bond markets – including the Treasury market, good grief! – are told by the Fed that core PCE inflation will be 4% to 5% and that core CPI will be at 5% to 6% for years to come, and that everyone will get used to it, and that the Fed will be happy with it, and won’t do anything about it, then the 10-year yield will spike to 6% or 7% to be above this long-tern new normal.

And mortgage rates will blow out. With the 10-year yield spiking to 6% or 7% in response to this much higher-than-expected inflation, the average 30-year fixed mortgage rate will spike to somewhere between 7% and 9%. And stay there.

Higher yields = lower asset prices.

The whole entire logic for low yields in the markets was based on low inflation rates. Core PCE was below the Fed’s 2% target for most of the 13 years between 2008 and 2021. And when it exceeded the Fed’s target for brief periods, it was only by a hair.

The entire QE philosophy since 2008 was based on low inflation, and on the now-crushed theory that QE won’t trigger and fuel inflation…..

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Continue reading this article at Wolf Street.

The Fed Is Bankrupt

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Estimated Reading Time: 3 minutes

Federal Reserve Chair Jerome Powell recently testified before Congress on the current state of the US economy. In addition to monetary policy, Powell was questioned about the Fed’s regulatory proposals regarding cryptocurrencies and climate-related financial risks.

Barely mentioned, however, was the Fed’s balance sheet. The Fed has experienced significant operating losses over the last six months, which have exhausted its existing capital. Those losses represent foregone revenue to the US Treasury.

Operating losses
In the post-pandemic period, the Fed expanded the money supply significantly to support a swift economic recovery. It did so by purchasing vast amounts of US Treasury bonds and mortgage-backed securities. While those assets seemed like good investments at first, they are now a major hole in the Fed’s financial position.

When the bulk of the Fed’s quantitative easing (QE) programs took place in 2020 and 2021, market rates on long-term Treasury bonds fluctuated mostly in the range of 1.5 to 2.0 percent. At the time, the Fed was paying interest on bank reserves and overnight reverse repurchase (ONRRP) agreements of 0.15 or less. The Fed profited on the difference between the higher rate it received from its bond purchases minus the lower rates it paid on reserves and Overnight Reverse Repurchases (ONRRPs).

Now, the Fed has raised the interest it pays to 4.55 percent on ONRRPs and 4.65 percent on bank reserves, but the rates it earns on its QE purchases remain mostly unchanged. Assuming, as a rough approximation, that the bonds it purchased pay an average rate of 1.75 percent, and the average rate paid on bank reserves and ONRRPs is 4.6 percent, then the Fed is paying about 2.85 percent per year more than it receives on its $8 trillion dollar securities portfolio. That’s a loss of $228 billion per year!

The bankrupt central bank
The Fed is bankrupt — and I don’t just mean intellectually.

Like a private bank, the Fed maintains some level of capital as a buffer against losses. When those losses exceed the value of its capital, the Fed becomes insolvent, meaning the liabilities it owes to others are greater than the total value of the assets it holds.

The most recent data show that the Fed owes the Treasury over $41 billion, which exceeds its total capital. The Fed, by common standards, is indeed insolvent.

Deceptively deferred assets
What does the Fed do when its liabilities exceed its assets? It doesn’t go into legal bankruptcy like a private company would. Instead, it creates fictitious accounts on the assets side of its balance sheet, known as “deferred assets,” to offset its increasing liabilities.

Deferred assets represent cash inflows the Fed expects in the future that will offset funds it owes to the Treasury. As the Fed describes, “the deferred asset is the amount of net earnings the Reserve Banks will need to realize before their remittances to the US Treasury resume.” The Fed had already accrued $41 billion in deferred assets, and the amount is only getting larger.

The advantage to deferred assets is that the Fed can continue its normal operations without disruption, although considering the 40-year-high inflation, its recent performance has been less than ideal.

The disadvantage is that, at a time when the Fed is already worsening the US fiscal position by raising interest rates (and therefore interest payments on the federal debt), it is further robbing the Treasury of revenues by deferring them into the future. Those deferred payments, of course, must be shouldered by American taxpayers until the Fed’s remittances resume.

These losses may be offset by any previous gains on the Fed’s QE portfolio, but assessing the net effects of those actions is even more difficult. QE has created massive distortions in the financial system. The Fed’s interest rate tools of interest on bank reserves and ONRRPs have significantly curtailed short-term lending in the banking and financial systems.

A job for Congress?
In addition to its role in managing the money supply, the Fed is the primary regulator of most US banks. If any private bank behaved this irresponsibly, regulators, such as the Fed or Federal Deposit Insurance Corporation (FDIC), would force it to close. Bank managers would lose their jobs and incomes.

Clearly, Congress is not planning to shut down the Fed, and is unlikely to punish it for its poor performance, but there are changes that could be made. The banks that are members of the Federal Reserve System could be forced to cover the capital shortfall, as described in the Federal Reserve Act. The Fed could return to a corridor system of monetary policy, resulting in lower interest paid on bank reserves and ONRRPs relative to market rates and therefore fewer reserves held at the Fed.

Shrinking the Fed’s balance sheet would make another Fed insolvency less likely, while also reducing the Fed’s footprint and the distortions it creates in the financial system. At very least, Fed officials should better manage its operations so as not to be a drain on American taxpayers again in the future.

*****
This article was published by The American Institute for Economic Research and is reproduced with permission.

Gold Near All Time Highs

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In early January 2021, we authored a brief article on gold.

In that article, we suggested some reasons we thought would be positive for the price of gold.  Since it has now been more than two years, it may be worth revisiting the subject and updating readers of The Prickly Pear on the current status of the gold market.

You can see on the chart provided that at the time we wrote our piece, gold was out of favor and trading around $1,675 per ounce, a level that it retested several times.  It made one final low, slightly below that level in November of 2022, and is now closing in on two previous highs made just above the $2,000 mark.

So far the advance has been orderly.  Since the turn of the year, gold is up about 8%, a slightly better showing than the stock market.  It is up about 21% since the lows last fall. We would be more concerned if gold was “going parabolic” or almost straight up.  Instead, it has avoided excess by backing and filling price action with an upward bias. It continues to climb towards the important old highs and acts like it wants to break them.

Old highs typically provide resistance, since the market previously peaked out at those levels, so getting through the old highs will mark an important milestone for the yellow metals.  If gold is able to do that, investors likely will start to pay closer attention and the market will become more active.

However, as we approach the old highs, gold will either fail again at around $2100 or will break out.  We soon should find out which it will be.

Without rehashing what we said two years ago, the reason gold may be rising is that the investing public is starting to recognize that no progress is being made on the deficit front. On the contrary, politicians of both parties think deficits are of no consequence.  The public has largely been out of gold over the past few years with ounces constantly flowing out of the popularly traded Exchange Traded Funds.  That looks like it is changing.

In terms of speculative positioning among futures traders, again, the public commitment by both traders and hedge funds is quite low.  There is no gold fever at present, and that is good.  There is plenty of room for speculative positioning to grow.

The one big buyer has been central banks, with 11 straight months of adding gold to their reserves.  China has been a particularly active buyer.

Meanwhile, the Biden Administration has introduced another blowout budget, this time without Covid and lockdown serving as an excuse.  And all this came after the Trustees of Social Security announced the insurance fund would be running out of money a year earlier than predicted, in just 10 years.

Rather than shoring up the finances of important “entitlements”, the Democrats are launching huge new initiatives based on global warming theory and even reparations for Blacks.

This is a message most likely that has not been missed by the market.  Either they don’t understand or they just don’t care.  Neither inspires confidence.

But while Biden is spending like mad, the Federal Reserve is trying to reverse years of easy money, fight inflation, and yet must do so in a way that does not break the banking system and/or plunge the economy into recession.  Instead of interest rates “higher and longer”, the FED may have to tolerate inflation “higher and longer.”  The odds of the nirvana of a soft landing seem to be growing more remote.

Clearly fiscal policy is completely out of step with current monetary policy.

Despite multiple increases in interest rates that should be supportive, the US dollar seems to have built a large “head and shoulders” type top, with a significant risk of breaking support around 101 on the dollar index.   Why the dollar weakness?

It could be the markets recognize the FED has finally painted itself into a corner and we can’t get out of the situation without making a terrible mess of things.  Dollar weakness may also portend that emerging powers like China no longer want to play by the Bretton Woods rules imposed after World War II but seek new arrangements not dominated by the US.

The US is now in an extended war with Russia and China is backing up Russia.  Wars are always inflationary and always cost much more than anyone anticipates.

There is increasing talk and actions being taken by other countries to settle trade among themselves without using dollars, pay for oil without using dollars, and hold reserves in a form not in dollars and outside of the Western banking system.  This in our view, is a result of the foolish steps taken by the Biden Administration to seize Russian foreign currency reserves.

Every country from Saudi Arabia to India, to China; saw the example of how the US could seize foreign reserves without any kind of judicial procedure.  Many countries no longer trust the US with their money, fearing exactly this kind of retaliation should they disagree with US policy.

India has been buying Russian oil and not paying for it in dollars and Japan has decided to break the US boycott and buy oil from Russia as well.  Countries generally friendly to the US are breaking out of the US monetary orbit.

Saudi Arabia is thumbing its nose at the US relative to oil production and also signals its intention to follow China’s overtures to restore relations with their arch-rival Iran.  The US is clearly losing influence in key areas of the world.

A weaker dollar historically has been quite positive for gold.  A revamping of the international monetary system may well utilize gold to a greater extent as a reserve and that might explain why central banks are buying gold for their own reserves at the fastest pace in 50 years.

Without requirements to use dollars to settle trade and buy oil, it reduces the demand for dollars, and the dollar then must stand on its own financial foundation, which is shot through with deficits and wild spending schemes.

If gold can break to new highs, what would be the likely upside targets we could expect?

That is very difficult to know, but we do have some history to guide us.  Gold in the 1970s started at $35 per ounce and ran to $200 in 1974 when gold was finally legalized in the US. Gold then fell off and bottomed in 1976 at $100 and moved to $860 by 1980.  Gold floundered for the next 20 years and bottomed out in 1999 just before the beginning of the financial crisis and the 9/11 attack at $250, and ended its move in 2011 at around $1900.

In short, in each previous bull market, gold swung from the cycle low to go up 7 to 8 times off that low.

Since the recent low was just above $1,600 a similar swing could put gold up around $11-12,000 per ounce.  Huh?

Even thinking such a thing makes me feel ridiculous. But that is what has happened in the past, and one has to ask this question:  Is it better or worse today in terms of the background conditions?  In many of those other moves, we didn’t have the money supply soar more the 20% in a year, central banks were not huge buyers of gold, we did not have a banking panic, and dollar hegemony was not being challenged by a rival superpower, and the Democratic Party was not an outright socialist party.  In previous times we were at war for some of the time and no one was imposing additional huge costs on society for “global warming”.

In all the previous cycles, whether you liked Nixon, Ford, Carter, or Bush, there was no doubt that the President of the United States was functionally in charge of his Administration.  That can’t be said about today, can it?

The country was not so nearly divided politically and nobody remotely thought that men could have babies.  We mention the latter, not as an economic condition, but as a statement as to how insane our world has become.

When the insane are in charge of monetary and fiscal policy, and just about everything else, bad things can happen.

It is not irrational to say conditions are worse today.  We lived through all those aforementioned cycles functioning as an investment professional, and we would sadly conclude that conditions today are worse in many regards than those in past cycles.  Debt burdens are much heavier and the character of the people is weaker and more dependent on the government. The rule of law is now seriously impaired and we are close to political tribal warfare.

While trust in government has been dropping, we cannot recall it being this low.  When the value of money is based only on faith and confidence, attitudinal shifts like those we are witnessing are not good for stability.

Therefore, it is hard to see reasons why gold will suddenly depart from previous behavior demonstrated in past market cycles.

But as to what the future holds, whether history is a guide in this circumstance is certainly arguable.  No one really knows or can know. All we can do is tell you what did happen in the past. But in the short term, getting through the old highs does complete a much larger historical formation.

Technical analysts call this a cup and handle formation, and it is an enormous rounded bottom, built over a very long period of time.

The “rules” used in such a formation is the market will generally rise above the rim of the cup line, the distance from the bottom of the cup to the rim of the cup.  Others say you should measure from the bottom of the cup to the breakout point on the “handle”. As you can see, either way of measuring it is around $1,000 dollars.   That would project something around $3,000 per ounce as an interim target using this methodology.

We make no pretense of having the last word on the subject.  None of this is science and history does not always repeat.  But as often noted, history may not always repeat exactly, but it usually rhymes.

The only thing we might offer is this:  if gold can break to new highs, it likely goes quite a bit higher.  How high will depend on how badly monetary affairs are mismanaged.

Stocks Remained Resilient in the First Quarter

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Now it was not a great quarter, but considering the banking failures and interest rate hikes, equities were remarkably resilient.  The gain of 7% or so in the broad market average was welcome.  The tech-laden NASDAQ was up 17%.  Recall the broad average was down 19% last year.

Gold was up about 9% and bonds as measured by the I shares Bond Aggregate were up about 3 1/2%.

Readers might remember that stocks broke upward out of a bear trend, then failed and dropped back below the trend, only to once again scramble back above major moving averages and trendlines.  Whew!

On March 22, the CNN Fear and Greed gauge hit a low of 22, an extremely oversold reading for sentiment.  As we write, it has rebounded back to 50, which is a neutral reading.  The low for the quarter in terms of price came on March 13, followed by a sharp rebound. But the swing in sentiment shows just how rapidly minds are changing in just a two-week period.

Apparently, Mr. Market figures the FED will not be raising rates anymore because the FED will not want to risk aggravating the banking crisis further.  Traders seem anxious to get back to the days of cheap money.  It is all they have known for almost 20 years so you can’t blame them.

Surely the banking problems will force the FED to pivot.  However, with inflation persisting, the FED either gives up on inflation or risks further banking difficulties.  Choosing inflation is not necessarily going to be great for the market, although we admit, that seems to be the working assumption right now.

In fact, the behavior of the market is very similar to what gave us the recent top.  During the recent rebound, once again a handful of high-capitalization tech stocks (much like the FANG stocks of previous fame) are creating the bulk of the gains for the index.  In fact, the equal-weight S&P, which removes the distortion of the FANG stocks, was up only half of the amount of the regular index.

Jesse Felder, an astute market analyst points out that the combination of Apple, Nvidia, Microsoft, Meta, Tesla, Amazon, Alphabet, Salesforce, and AMD have contributed ~160% of the S&P gains so far this year.

Without just this handful of companies, the averages would be negative.

Generally speaking, a healthy market shows broad participation in price improvement. Narrow price strength, particularly in such small numbers of huge companies, is not healthy.  So, while the percentage recovery shows a decent quarter, the way we are getting it is unhealthy. Bulls better hope the price strength spreads soon to many more companies.

Moreover, those companies creating most of the gain are extremely expensive in terms of their market metrics.  It would be unusual, to say the least, for companies that are already extremely expensive, to be able the lead the market higher on a sustained basis.

The banking crisis seems to have come and gone rather quickly, too quickly we think.  Deposit outflows from banks continue, which suggests the problem is not over.  Not only do continued withdrawals risk ensnaring marginal banks in liquidity problems, but deposit outflows will also cause banks to be more reticent to lend except to the most credit-worthy borrowers.  That will tend to deny access to credit by the marginal borrower.  Couple that with higher interest rates already in place, and it would seem this will be a factor to slow the economy.  Some people will not be getting credit when they want and need it and many have substantial debts to roll over.

In addition, OPEC suddenly and surprisingly announced production cuts, which will add to the price of energy, which will most likely add to the inflation problem, which will make it difficult for the FED not to follow through with more rate hikes.

Japan has said they will be buying Russian oil, weakening the Western Alliance insofar as their using sanctions to bring Russia to heel.

The political front has not improved much either.  Worries about the debt ceiling crisis have also faded fast as well but the problem remains unresolved.  Speaker Kevin McCarthy says the GOP seeks concession but the White House for two months has refused to even talk to House Republicans.  In fact, this problem is still very much in play and the White House has gone beyond brinksmanship into what appears to be a political coma.  Democrats seem extremely confident that Republicans won’t be able to stick together.

If Republicans can stick together and propose common sense cuts, such as a return of government spending to pre-Covid levels, they could put the Democrats in the position of threatening default on the debt of the US.

Meanwhile, another warning was issued suggesting that Social Security will run out of money in just a decade.

A number of countries are taking preliminary action to dethrone the US dollar as the reserve currency and oil payment currency of the world.  This seems like an arcane subject to many but it is fraught with serious implications.

Right now, our government, and only our government, can print money to satisfy foreign debtors and pay for oil.  No one else can do that.  It is doubtful the average voter understands how serious it will be for our standard of living if the dollar is knocked from its pedestal.

In summary, the gains are welcome but are on shaky grounds. Most of the problems plaguing the market remain unresolved.