Tag Archive for: FederalReserveFailures

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 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.

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.

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

‘No Painless Option’: Fed Faces Tough Choice on Inflation Following Bank Collapses

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Estimated Reading Time: 3 minutes

The U.S. Federal Reserve may be less likely to use its key tool to combat inflation because of recent bank failures.

The Fed has been aggressively hiking interest rates for months to help combat inflation. While inflation has slowed, it remains elevated. Given the recent bank collapses, hiking rates again may be too risky for the Fed.

“The Federal Reserve is going to have to pick its poison – tolerate some inflation for a bit to see if its current series of rate hikes takes hold and pause or keep hiking and deal with the financial instability caused by their own policy decisions,” Jamie Cox, managing partner for Harris Financial Group in Virginia, said in a statement.

Raising rates at this time would likely be hard on the markets and the banks, but not raising them would likely mean higher inflation for much longer.

“The Fed has a choice to make about inflation: It can bring it down now, likely with a little bit of pain,” Ryan Young, senior economist at the Competitive Enterprise Institute, told The Center Square. “Or it can bring it down later, with a lot more pain. There is no painless option.”

The Federal Reserve meets March 22, and is expected to announce its decision then. The group could try to split the difference with a small rate hike.

“Politicians don’t like tradeoffs, which is why Sen. Elizabeth Warren and others are pressuring the Fed to stop raising interest rates,” Young said. “But the right thing to do is to get inflation back down. [Federal Reserve] Chairman [Jerome] Powell, for all his earlier mistakes, appears committed to finishing what he started.

“A strong labor market makes the Fed’s decision easier, although Silicon Valley Bank’s failure makes it tougher,” he added.

Powell testified before the Senate Banking Committee earlier this month where he said bigger rate hikes could be necessary to address inflation, though that was before the collapse of multiple banks in recent days.

“The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated,” he said at the time.

The Fed raised interest rates seven times in 2022 alone. Now, experts are worried and say Americans may have to live with inflation.

“The Fed needs to hit pause and assess the full impact of its actions so far before raising short rates further,” Sheila Bair, the former chair of the Federal Deposit Insurance Corporation, told CNN.

Living with the higher prices would be hard on many Americans. The U.S. Bureau of Labor Statistics released the Consumer Price Index Tuesday, which showed consumer prices rose 0.4% in February, totaling a 6% increase over the previous 12 months. Once again, wages have failed to keep up with rising consumer prices.

Some prices surpassed the national average. Shelter, for instance, rose 0.8% in February alone, part of an 8.1% increase in the past year. And while food prices rose at the 0.4% rate, those prices have risen 9.5% in the previous 12 months. Energy prices dipped slightly, a change from the major increases in recent years.

“Core CPI came in hot: 0.5% for the month as opposed to the (still hot) 0.4% expected,” Jason Furman, an economist and Harvard Professor, wrote on Twitter. “Core CPI higher for the month than the three months than the six months.

“Core CPI came in at a 5.6% annual rate for the month of February,” he added. “In the 25 years before COVID, the single highest monthly print (out of 300 prints) was a 4.6% annual rate.”

Young said federal policy was partially to blame for the bank collapses.

“That failure didn’t come out of a vacuum, however,” he said. “The Fed kept interest rates artificially low for a long time. Businesses responded to their incentives by taking on foolish risks that they otherwise wouldn’t have. When interest rates started coming back up, as was going to happen sometime, one of the tradeoffs is that some bad bets were going to go bad. SVB’s case is a combination of years of bad management and years of bad government policy.”

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This article was published by The Center Square and is reproduced with permission.

Can Markets Function Normally With Intrusive Central Planning?

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Estimated Reading Time: 6 minutes

Editors’ Note:  On Friday, March 10, Silicon Valley Bank collapsed, the second largest bank failure in US history.  There is common wisdom that the FED keeps raising rates “until something breaks.”  There is likely no bigger single market intervention than the manipulation of interest rates. Along with the meltdown in cryptocurrencies, their banks, and exchanges, pension funds in the UK; this is the first really large banking failure.  Officials in 2007-2008 suggested banking troubles were “isolated events”, but history proved later that was not correct.  It will be very important to see how far the rot has spread in our financial system.  Most all banks that own long-dated US Treasuries and mortgage-backed securities are taking large losses because of the FED sharply raising rates. These events illustrate the problem the FED must deal with.  Having blown a huge financial bubble with cheap money, they must now deflate the bubble, but at the same time hope they can avoid the collateral damage that could plunge the economy into recession.  If they back off too early, they lose the inflation fight.  If they persist too long, they risk a recession.  Trying to thread the policy needle just right represents a substantial risk to the financial markets.

 

As readers may be aware of our past stock market commentaries, the stock market is at an important juncture.  After last year’s bear market of a bit better than 20%, stocks started to rebound this year.

Historically, it is normal for the third year of a Presidential term to be bullish.

A rally from the worst of Covid-related economic trauma would also be expected.

The market seems to be going through a series of conflicting mental states:  the economy will have a soft landing, the economy will have no landing at all, and recently, the economy will have a hard landing.

The recent rebound created internal strength and momentum sufficient that it has convinced a fair number of commentators, mostly of a technical stripe, that a new bull market in equities has begun. In their defense, the market did break its bear linear trend line and turn up major moving averages. It has a high number of “breadth thrusts”, high volume days where advancing issues swamp declining issues. So, it is indisputable that the market is acting better.


Curtesy of stockcharts.com

Oddly though, after the “break out” the market decided to confuse everyone even further by diving back to the breakout point and then fiddling around in narrow a range as we write. In part, this was because of Congressional testimony by FED Chairman Jerome Powell, who expressed a “higher for longer” position on interest rates.

Is it a new bull market or a bear market rally?  Our best estimate has been that it is a bear market rally. Given the retreat back down to resistance we would have to say, the “break out” remains unresolved and thus a trend in force remains in force until proven otherwise. The trend in force has been a bearish downward trend.

We suggested this is a bear market rally based on the “weight of the evidence,” both fundamental and technical, although we frankly thought the market advance would last a bit longer than it did. Did Powell kill the baby in the crib?

The technical strength remains impressive. Even after more talk of higher interest rates, the market has refused to cave in. Instead, it fell right back to the resistance area, but so far has held…barely. However, it is fair to say that conditions are so fluid right now, it is probably best to avoid dogmatism.

For those of a more fundamental view, their concerns include the likelihood of a recession caused by rising interest rates, an inversion of interest rates, a decline in corporate earnings,  a housing slump, a historic decline in the money supply, and increasingly stressed consumers. On the positive side, employment remains buoyant and unemployment is at very low levels.

It is also historically rare for a major bull market to begin with valuation levels still as high as they are. There has been a bear market for sure, but it is far short of the “average” bear market loss of 36% and given the credit excesses and valuation excesses of this Supercycle, it would seem a bit odd to end this affair with such a modest correction.

The technical analysts counter this with an important argument. The very nature of their system posits that all known factors are incorporated into the price structure. In other words, all the worries about recession and interest rates, and concerns about earnings and whatever, are known, and still, the market has decided it still wants to rise.

If we are all talking about these troublesome issues, they are known. If they are known, the market is already incorporating that in the price structure.

Since we use both technical and fundamental analysis in our own thinking, we do not have an ax to grind for either school of thought. Both are valid ways of making judgments about the market. Neither is perfect so the more supporting information you have, from either camp, the better your odds of making a correct decision.

The deeper question is whether either school of analysis can function well in an environment of heavy-handed central planning that is driven by a political agenda.

It has become obvious that some of the “data” that fundamentalists use are altered by government policy and the FED itself. Greater government benefits and societal changes have made it possible for something on the order of seven million men of prime age to disappear from the labor market. That does make the labor market look tighter than it otherwise would be.

Central planning supposedly involves a degree of secrecy, otherwise, those who know what policy shifts will occur can profit. However, it is amazing the number of congressmen and congresswomen, and even FED officials who have speculated on stocks given their privileged position to get inside information first. It would appear that ethics is no match for the self-interest of bureaucrats and politicians.

It can be argued that if that is the case, then the market does have information because buying or selling activity is occurring, spreading the information.

But how far must information be dispersed before markets get a true reading of demand? Nancy Pelosi herself should not be able to move markets, even if she and her husband may trade on inside information.

The theory of central planning also assumes there is a central plan. What if the FED simply makes things up as they go along, caves into political pressure, or is immersed in internal conflict that makes the mission less certain? The same can be said for the Biden Administration.

More frightening, what if they don’t know what they are doing yet are conducting a grand monetary experiment with Quantitative Easing, Quantitative Tightening, and Modern Monetary Theory?

We have never been in a situation where we are spending and borrowing on a scale of World War II, all in peacetime, and all on top of preexisting huge debt. There are scant historical examples to guide us through our current predicament. We are in a new historical territory almost every day.

You can readily see it is hard for markets to incorporate information into the price structure when there is little rhyme or reason to what central planners are doing. Improvisation of policy is difficult to discount unless you know what the whims of the prince will be. But if it was planned, it wouldn’t be a whim, would it?

Markets today may in fact be more like a gambling casino changing rules frequently based on the whim of the mob boss. If so, how well can markets discount future events and trends?

We do have markets today that jump around frequently not only the statements of officials in various venues, but also we have politically manufactured data that frequently get “revised.” Unless one has advance notice of what these spokesmen will be saying, it is pretty much a guess as to what they will be saying. The next guess is how will the market react to the latest statement.

Readers might recall the fall and winter of 2018 when the FED said they would raise interest rates.  As soon as the markets began to correct, the FED immediately changed course. It was a monumental whipsaw for investors and under these circumstances, it seems difficult for markets to incorporate such fluid decision-making into the price structure.

Our point is that central planning today is more like planned chaos and is not often conducted either with consistent political or economic principles and is driven by pollsters.

Such conditions argue for intellectual modesty regarding a new direction for the market.

Finally, there is the problem central planning has always had. It relies little on market data and more on political whim. Because it does not rely on true supply and demand, central planning has never worked. You cannot make rational economic calculations absent true free market forces.

It is an open question as to how well markets can truly function in today’s era of central planning.

Markets must deal not with just what direction the economy may be going, but more often, with what direction intrusive government policy is going.

The FED is moving interest rates, the government is selling oil from the Strategic Petroleum Reserve, NATO is sanctioning Russian oil, government skews lending to diversity and equity, economic growth takes a back seat to environmental zealotry, and there is a general regulatory jihad against business in general. Recently, Treasury Secretary Yellen says she now believes “climate change” can alter the value of securities.

How good are our tools of analysis, technical and fundamental, under circumstances of constant and incessant interference by the government?

Probably not as good as we would like them to be.

Amidst all this, we accept the primacy of the dictum of “don’t fight the FED.” Right now, the markets seem like they want to fight the FED. Because of that, we prefer caution. Eventually, the markets will get a better sense of direction when we are closer to the end of this interest rate hiking cycle. We will find out if we indeed have had a breakout or a head fake.

Yellen Blaming Consumers for Inflation Is Government’s Latest Attempt to Deflect Blame for Its Policies

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Estimated Reading Time: 6 minutes

A few weeks ago, US Secretary of the Treasury Janet Yellen appeared on the Late Show With Stephen Colbert to discuss a range of issues both political and personal.

The most widely reported moment in the interview came when Yellen talked about practicing her signature (don’t ask me why this is newsworthy, I have no idea). However, a significantly more important moment has not gotten the attention it deserves.

When asked by Colbert to explain the reasons behind the worst inflation the US has experienced in 40 years, the former Federal Reserve chair blamed it primarily on rising consumer spending—Americans “splurging” on goods—at the start of 2021 once the Covid-19 lockdowns were lifted. This, compounded with supply chain issues and the war in Ukraine can sufficiently explain inflation, Yellen claims.

But can it really? Let’s take a closer look.

The Real Reason For Inflation

Yellen’s explanation is not wholly inaccurate; it is true that consumer spending rose above pre-pandemic levels at the start of 2021 and continued to rise at a notably fast rate for many subsequent months—which puts upward pressure on prices. At the same time, this is in no way a complete explanation of the inflation we are seeing now.

Yellen’s explanation does not capture inflation’s primary culprit, both in this case and historically: expansionary monetary policy. From February 2020 to February 2021, the money supply as measured by M2 (the broadest measure of the money supply) increased by 27 percent. It increased by another 11 percent from February 2021 to February 2022. This means that, over the first two years of the Covid pandemic, the money supply increased by 41 percent. To put that in perspective, from 2010 to 2019, this measure of the money supply rose by 5.8 percent annually.

In a 60 Minutes interview, Chairman of the Federal Reserve Jerome Powell replied “Yes, we did,” when asked if he simply “flooded the system with money” during the pandemic.

The consequence of such a drastic rise in the money supply is clear: a drastic rise in inflation.

The Evidence

The reason this is the case should be intuitive (increasing the amount of money in the economy boosts the relative demand for goods and services, which puts upward pressure on prices) but it can also be demonstrated theoretically and examined empirically using what is known as the quantity theory of money. This theory has roots that can be traced back hundreds of years but remains as relevant as ever today, with most economists accepting its core insight as accurate.

The quantity theory of money is based on the “equation of exchange”: MV=PY, where M is the quantity of money, V is the velocity of money (the average frequency at which a unit of money is used to purchase goods during a given period), P is the average price level, and Y is real GDP.

If the value of one side of the equation rises or falls, there must be a similar shift on the other side. Based on this, we can understand that there is a positive relationship between money supply and price level, all other variables held constant.

This is particularly true if we accept that a nominal variable such as money cannot influence a real variable like GDP (Y); it would mean that the entire impact of a rising money supply falls on price level, rather than price level and real GDP).

In the context of the economic developments since February 2020, it becomes clear why we now see inflation. M rose dramatically for a two year period; however, it initially did not cause a hike in the left side of the equation (MV) because of a decline in V at the start of the pandemic. But once V inevitably adjusted back to baseline as restrictions were lifted, MV rose and an increase in the left side of the equation (PY) was necessary in order for the identity to hold. The spike in price level (inflation) following a rapid rise in the money supply and a return of other variables to their baseline could have easily been predicted using this theory and equation.

Put simply, as the supply of any good, including money, increases, the value of that good will fall relative to the value of other goods. In other words, creating more money means money will have a lower purchasing power than if the money was not created.

That this is the proper explanation for inflation, and that the quantity theory of money remains valid, is borne out empirically. The graph below—created by two economists at Johns Hopkins University and presented in the Wall Street Journal—shows expected inflation based on the quantity theory of money equation (MV=PY) plotted next to actual inflation as measured by the GDP deflator over the past 60 years. The extent to which the two track is striking. The only deviation from the relationship took place at the start of the Covid-19 pandemic; but, by the middle of 2021, the equation of exchange was once again a near perfect predictor of inflation. This suggests that the quantity theory of money certainly reflects the real world workings of the economy in that price level is heavily influenced by money supply. It thus vindicates the proposition that the Federal Reserve’s expansionary monetary policy is the primary reason for inflation.

As a final note, it should be mentioned that all of this was exacerbated by expansionary fiscal policy. At the same time that the money supply was increasing, politicians in Congress passed several stimulus bills—nearly all of them topping a trillion dollars.

Astonishingly, these bills did not stop when inflation began. In March 2021, Democrats passed, and Joe Biden signed, the $1.9 trillion American Rescue plan which sent billions of dollars in direct stimulus checks. Then, in August 2022 the so-called Inflation Reduction Act was passed, which added more than $500 billion in new spending and tax breaks. Insofar as an increasing money supply enables increasing government spending, it puts upward pressure on prices, which means the inflation we see today really was a team effort between the Federal Reserve and Congress.

The Art of Shifting Blame

It should be self-evident that the explanation given above for inflation is not one that the people in charge of monetary and fiscal policy would be happy with. The reason is simple: it suggests they are culpable for the inflation we have experienced.

The first response was that it was merely “transitory.” Jerome Powell claimed, in March 2021, that “these [are] one-time increases in prices.” Yellen concurred saying, “I really doubt that we’re going to see an inflationary cycle.” Former White House Press Secretary Jen Psaki told reporters that inflation was only going to have “a temporary, transitory impact.”

All of these claims turned out to be completely untrue, as even those who pushed that idea at the start have now recognized.

Then, politicians including, but not limited to, Senators Elizabeth Warren and Bernie Sanders jumped on the idea that “corporate greed” was the real reason inflation was rising. As Brad Polumbo points out, though, the issue with this talking point is twofold: 1) “corporations are no more ‘greedy,’ aka profit-seeking, than they were 5 years ago or 10 years ago, when inflation wasn’t surging” and 2) producer prices have risen more than consumer prices, suggesting “companies haven’t jacked up prices to even fully match the increase in their costs, let alone exceed them.”

The “greedflation” argument amounts to nothing more than a politically-motivated conspiracy theory.

The White House has also taken advantage of Russia’s war on Ukraine to dub inflation “Putin’s price hike.” Nevermind the fact that inflation — including gas prices — were already up prior to Russia’s invasion, plenty of people went along with this line of argument anyway. This supply shock caused by the war would also be accounted for in the real GDP term of the equation of exchange. Since real output hasn’t yet fallen significantly in the US, it’s unlikely that this is the primary cause of inflation. It is true that the invasion has made inflation worse, but it is certainly not the cause of inflation.

And now, with Yellen’s recent interview, it seems that the narrative has shifted once again—to blaming inflation on Americans for spending too much.

There is a pattern here: no matter what happens, technocrats, bureaucrats, and politicians find a way to blame everything and everyone—except for their own policies and actions—for the situations we find ourselves in. This is true regarding inflation; this is true regarding school closures and subsequent learning loss; this is true regarding failed Covid-19 lockdowns.

Nobel Prize winning economist Milton Friedman could have (and did) predict this precise sequence of events almost 50 years ago.

He said that “If you listen to people in Washington (…) they will tell you that inflation is produced by greedy businessmen or it’s produced by grasping unions or it’s produced by spendthrift consumers.”

As we have seen, this is certainly still the case today. However, Friedman points out that the core issue with those ideas is that “neither the businessman, nor the trade union, nor the [consumer] has a printing press in their basement on which they can turn out those green pieces of paper we call money.”

So, what is the cause of inflation? Friedman argues: “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

There is no better description of the period between February 2020 and February 2022. The government first shut down production during lockdowns—with residual effects being felt for a substantial period of time afterward due to the friction inherent in our economy—while simultaneously increasing the money supply at staggering rates.

The question we should be asking those in charge is simple: what other outcome could there have been other than rising inflation?

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This article was published by FEE and is reproduced with permission.

Are The Bond Vigilantes Looking for a Hanging?

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Estimated Reading Time: 6 minutes

Prior to 2000, it was common in the economic and investment literature to read about “bond vigilantes.”Credit for the term is generally given to investment guru Edward Yardeni.

James Carville, the snake-headed political advisor to the Clinton campaign in 1994, remarked that if there were such a thing as reincarnation, he would like come back as the bond market.

He was referring to the power the bond market has when it is allowed to operate, to inflict economic pain, and thereby reorder politics.

Both the theory and the actual operation of the bond market go something like this: As spending rises to unsustainable levels, bondholders demand higher interest rates for their risk of suffering a default by the issuer. Likewise, with inflation, often caused by excessive debts and spending, bondholders know they will be paid off at the end with money far less valuable than it was when they made their purchase, and they too will extract higher interest rates as compensation for inflation risk. In short, the market raises rates, with or without the FED.

Prior to 2000, bond vigilantes, while not doing a perfect job, helped keep government debt and deficits within reason, even when our politicians and institutions failed to do their job.The bond market and interest rates, sort of like the old gold standard that was abandoned, remained the only market-based external discipline in the system.

And like the discipline of the gold standard, central bankers needed to make an end run around the bond vigilantes just as they did with gold.

Under the Clinton White House and the Gingrich House of Representatives, helped by the pain inflicted by the bond vigilantes, the country enjoyed a short period of balanced or near-balanced budgets. The last one was in 2001.

Then the Federal Reserve embarked upon its binge of bailouts, utilizing policies perfected by the Bank of Japan, so-called Quantitative Easing. The tech crash in 1999-2000, then after the 9/11 attack and Mid-East wars, and then the 2008 financial panic, all seemed to demand the FED “do something” to stop the pain.

The FED accommodated both the Bush Administration and the Obama Administration, keeping the bond vigilantes at bay while spending and deficits rose and rose. Trump, while acting conservative in many ways, largely ignored debt and deficits as well.

While the Fed made a modest attempt to curtail QE and lift rates from zero in 2018, a stock market slump late in that year chased them off. They did not have the nerve to follow through.  

We basically had 20 years of zero rates with expansive monetary and fiscal policy.

QE entails the Federal Reserve buying massive amounts of government debt (bonds and even mortgages). Where does the FED get the money to make these purchases? You guessed it, they printed it electronically.

The net effect was to sop up trillions in bonds that otherwise would have had to be dumped into the marketplace, which would have resulted in bond prices falling. By boosting demand for bonds artificially, they boosted bond prices artificially, and that artificially drove interests down to near zero and held them there for almost 20 years.

That has never occurred before in recorded economic history.

Zero rates and QE basically freed politicians from the last budgetary discipline that existed. The bond vigilantes could not do their job.

What would you expect politicians to do when freed from such discipline? Even with it abundantly clear that negative demographics and underfunded entitlement programs would increase deficits for years to come, new programs and new wars were always necessary.

But the money created by the FED stayed largely within the banks until Covid when the government began to just send out checks directly to the public. With the bond vigilantes essentially eliminated, politicians from both parties, but especially Democrats, went on a spending spree.

As they spent, there seemed to be no real inflation, in the classical sense.  Some have argued it was because of productivity gains, globalization, aging of the population.Whatever it was, politicians and central bankers decided to stimulate the economy even during relative prosperity because they thought they could do it without inflationary consequences.

Covid gave them even greater opportunities and the adoption by Democrats of Modern Monetary Theory gave them intellectual cover. Now it seems the next emergency that must be funded by gigantic deficits is global warming.

It was all gain and no political pain.

But then things shifted. The money supply blew up 40% in 18 months, an unprecedented economic event, especially for the issuer of the global reserve currency. Inflation rose to near double-digit levels. Inflation rose sharply in most other parts of the world. Biden and the FED said it was “transitory”, but instead it has become entrenched. The FED reluctantly reversed course by raising interest rates and selling bonds from their balance sheet.

The US was not alone in this mess. Some foreign central banks were even more aggressive, some even purchasing assets like stocks and not limiting themselves to government bonds or government-guaranteed instruments. Globally speaking, debt has grown to about 350% of global GDP. Now, in less developed and developed economies, all countries are raising rates to one degree or another. It is starting to squeeze the global debt bubble.

As a result,  bonds have had one of the worst years on record, and rates have not likely reached their peak. Home mortgage rates have virtually doubled. All manner of speculative activities, from SPACS and Cryptocurrencies to the stock market, have been plunging. Just in stocks alone,  some $7.5 trillion have been lost so far this year. The bond vigilantes are riding again.

In some countries such as Great Britain, last week the bond market virtually collapsed and interest rates are soaring. The British Pound has fallen to a 40-year low. At least in the short term, the crisis reached a dangerous threshold, causing the Bank of England to pivot, that is to say, start QE again to save their bond market and the Pound. Thus, short-lived discipline was abandoned as the central bank pivoted back to inflationary easy money policies.  

The quick reversal by the Bank of England was also prompted because pension funds that own bonds and bond derivatives are getting into trouble.

It also appears several large financial institutions, Deutsche Bank, Credit Suisse, and Softbank, are teetering with their stock prices plunging.  The risk of financial contagion is rising.

The question is: are the bond vigilantes back or will the central banks once again “pivot” and try to neuter them again?

The US FED says it will persevere in raising rates until the inflation fever breaks. But their record both at prediction and in keeping their word is poor. The risk of policy error is high. The FED is raising rates into an early-stage recession.

It would seem that the bond vigilantes are back, at least for now, and they are looking to hang some people. Some of these will be politicians, who like Biden, will not be able to escape responsibility for the inflation and high-interest rates they have inflicted on the citizens.

But many innocents will be hurt. The young will not be able to afford a house, investors will lose trillions, and many will be forced to default. Some will lose their jobs.

One man’s debt is often another man’s asset. When you default on a loan, the person or entity that lent the money loses. One man reduces his debt, the other loses his shirt.

Once the bond vigilantes start to ride, the terror of default and failure will spread with their pounding hoofs.

If the central banks pivot too soon, they will lose credibility, and hope of controlling inflation will be lost.

Politicians and central bankers thought a perpetual motion government spending machine seemed to have been invented. In the end, it has put many nations into a real bind. Either run the risks of hyperinflation and avoid recession or allow interest rates to rise and cause a recession.

Remember, the recession is that part of the business cycle that corrects the excesses of the boom.

What makes it worse this time, is the same folks that brought you inflation now have a new scheme to make things worse.

In the midst of this painful, and dangerous process, they want to inflict on the world a new energy system, that is both expensive and unproven. Creating both a food and energy crisis, in the midst of a recession, will be something new again that we have not seen in any previous business cycle.

So, as your energy bills climb and the food budget is stretched, and your investment portfolio plunges; keep in mind the pain is all a product of bad policies, policies that could have been blocked in the narrowly divided US Senate. The only hope is to vote them out of office,  the people who brought you these bad policies. If that can be done, the problems they created will remain but at least, they won’t get even worse.

The Senate is almost perfectly divided so the Senatorial races are key.

Mark Kelly could have been a hero to Arizona and the nation.  He could have stopped most of the mad spending that forced the FED to accommodate them. True, Manchin and Sinema did cave in the end, but Mark Kelly has never lifted a rhetorical or voting finger to stop the financial madness. Had Manchin and Sinema just had another ally or two, they might have held. 

But Mark Kelly was silent during the struggle, apparently too busy being Biden’s and Schumer’s poodle to care.

If we can’t find politicians with the gumption to control our finances and allow the private sector to produce energy, we will have to deal with the bond vigilantes. They will hang us all without mercy.

And that means people like Mark Kelly, who sounds like a moderate, but votes with Biden 94% of the time, have to go.

 

 

 

The Fed’s Tough Year

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Estimated Reading Time: 10 minutes

The powerful and prestigious Federal Reserve is having a tough year in 2022 in at least three ways:

  • It has failed with inflation forecasting and performance;
  • It has giant mark-to-market losses in its own investments and looming operating losses;
  • It is under political pressure to do things it should not be doing and that should not be done at all.

Forecasting Inflation

As everybody knows, the Fed’s overoptimistic inflation forecasts for the runaway inflation year of 2021 were deeply embarrassing. Then the Fed did it again for 2022, with another wide miss. In December 2021, it projected 2022 Personal Consumption Expenditures inflation at 2.6%, while the reality through June was 6.8%, with Consumer Price Index inflation much higher than that. It would be hard to give the Fed anything other than a failing grade in its supposed area of expertise.

The Fed’s interest rate forecast for 2022 was three federal funds target rate increases of 0.25% so that its target rate would reach 0.9% by the end of 2022. It forecast the rate at 2% by the end of 2024. Instead, by July 2022, it already reached 2.5%.

In short, the Federal Reserve cannot reliably forecast economic outcomes, what the results of its own actions will be, or even what its own actions will be. Of course, neither can anybody else.

It is essential to understand that we cannot expect any special economic or financial insight from the Federal Reserve. This is not because of any lack of intelligence or diligence, or not having enough computers or PhDs on the payroll, but of the fundamental and inevitable uncertainty of the economic and financial future. Like everybody else, the Fed has to make decisions in spite of this, so it will unavoidably make mistakes.

We should recall how Ben Bernanke, then Chairman of the Federal Reserve, accurately described his extended “QE” strategy in 2012 as “a shot in the proverbial dark.” That was an honest admission, although unfortunately, he admitted it only within the Fed, not to the public.

The Governor of the Reserve Bank of Australia (their central bank) described the bank’s recent inflation forecasting errors as “embarrassing.” Such a confession would also be becoming in the Federal Reserve, especially when the mistakes have been so obvious. The current fed funds rate of 2.5% may sound high today, if you have become used to short-term rates near zero and you have no financial memory. But it is historically low, and as many have pointed out, it is extremely low in real terms. Compared to CPI inflation of 8.5%, it is a real interest rate of negative 6%.

Savers will be glad to be able to have the available interest rates on their savings rise from 0.1% to over 2%, but they are still rapidly losing purchasing power and having their savings effectively expropriated by the government’s inflation.

Although in July and August 2022 (as I write), securities prices have rallied from their lows, the 2022 increases in interest rates have let substantial air out of the Everything Bubble in stocks, speculative stocks in particular, SPACs, bonds, houses, mortgages, and cryptocurrencies that the Fed and its fellow central banks so assiduously and so recklessly inflated.

A Mark-to-Market Insolvent Fed

Nowhere are shrunken asset prices more apparent than in the Fed’s own hyper-leveraged balance sheet, which runs at a ratio of assets to equity of more than 200. As of March 31, 2022, the Fed disclosed, deep in its financial statement footnotes, a net mark-to-market (MTM) loss of $330 billion on its investments. Since then, the interest rates on 5 and 10-year Treasury notes are up about an additional one-half percent. With an estimated duration of 5 years on the Fed’s $8 trillion of long-term fixed rate investments in Treasury and mortgage securities, this implies an additional loss of about $200 billion in round numbers, bringing the Fed’s total MTM loss to over $500 billion.

Compare this $500 billion loss to the Fed’s total capital of $41 billion. The loss is 12 times the Fed’s total capital, rendering the Fed technically insolvent on a mark-to-market basis. Does a MTM insolvency matter for a fiat currency-printing central bank? An interesting question—most economists argue such insolvency is not important, no matter how large. What do you think, candid Reader?

The Fed’s first defense of its huge MTM loss is that the loss is unrealized, so if it hangs on to the securities long enough it will eventually be paid at par. This would be a stronger argument in an unleveraged balance sheet, which did not have the Fed’s $5 trillion floating rate liabilities. With the Fed’s leverage, however, the unrealized losses suggest that it has operating losses to come if the higher short-term interest rates implied by current market prices come to pass.

The Fed’s second defense is that it has changed its accounting so that realized losses on securities or operating losses will not affect its reported retained earnings or capital. Instead, the resulting debits will be hidden in a dubious “deferred asset” account. Just change the accounting! (This is exactly what the insolvent savings and loans did in the 1980s, with terrible consequences.)

What fun it is to imagine what any senior Federal Reserve examiner would tell a bank holding company whose MTM losses were 12 times its capital. And what any such examiner would say if the bank proposed to hide realized losses in a “deferred asset” account instead of reducing its capital!

Here is a shorthand way to think about the dynamics of how Fed operating losses would arise from their balance sheet: The Fed has about $8 trillion in long-term, fixed-rate assets. It has about $3 trillion in non-interest-bearing liabilities and capital. Thus, it has a net position of $5 trillion of fixed rate assets funded by floating rate liabilities. (In other words, inside the Fed is the financial equivalent of a giant 1980s savings and loan.)

Given this position, it is easy to see that pro forma, for each 1% rise in short-term interest rates, the Fed’s annual earnings will be reduced by about $50 billion. What short-term interest rate would it take to wipe out the Fed’s profits? The answer is 2.7%. If their deposits and repo borrowings cost 2.7%, the Fed’s profits and its contribution to the U.S. Treasury will be zero. If they cost more than 2.7%, as is called for in the Fed’s own projections, the Fed starts making operating losses.

How big might these losses be? In the Fed staff’s own recent projections, in its most likely case, the projected operating losses add up to $60 billion. This is 150% of the Fed’s total capital. In the pessimistic case, losses total $180 billion, over 4 times its capital, and the Fed makes no payments to the Treasury until 2030.

In such cases, should the Fed’s shareholders, who are the commercial banks, be treated like normal shareholders and have their dividends cut? Or might, as is clearly provided in the Federal Reserve Act, the shareholders be assessed for a share of the losses? These outcomes would certainly be embarrassing for the Fed and would be resisted.

The central bank of Switzerland, the Swiss National Bank (SNB), did pass on its dividends in 2013, after suffering losses. The SNB Chairman gave a speech at the time, saying in effect, “Sorry! But that’s the way it is.” Under its chartering act, the SNB—completely unlike the Fed—must mark its investment portfolio to market in its official profit and loss statement. Accordingly, in 2022 so far, the SNB has reported a net loss of $31 billion for the first quarter and a net loss of $91 billion for the first six months of this year.

The Swiss are serious people, and also serious, it seems when it comes to central bank accounting and dividends.

In the U.S., the Federal Reserve Bank of Atlanta did pass its dividend once, in 1915. As we learn from the Bank’s own history, “Like many a struggling business, it suspended its dividend that year.” Could it happen again? If the losses are big and continuing, should it?

A third Fed defense is that its “mandate is neither to make profits nor to avoid losses.” On the contrary, the Fed is clearly structured to make seigniorage profits for the government from its currency monopoly. While not intended by the Federal Reserve Act to be a profit maximizer, it was also not intended to run large losses or to run with negative capital. Should we worry about the Fed’s financial issues, or should we say, “Pay no attention to the negative capital behind the curtain!”

The Fed is obviously unable to guarantee financial stability. No one can do that. Moreover, by trying to promote stability, it can cause instability.

What the Fed Can and Can’t Do Well

The Federal Reserve is also suffering from a push from the current administration and the Democratic majority in the House of Representatives to take on a politicized agenda, which it probably can’t do well and more importantly, should not do at all.

This would include having the Fed practice racial preferences, that is, racial discrimination, and as the Wall Street Journal editors wrote, “Such racial favoritism almost certainly violates the Constitution. So does the [House] bill’s requirement that public companies disclose the racial, gender identity and sexual orientation of directors and executives.” The bill would “politicize monetary policy and financial regulation.” A lot of bad ideas.

Moreover, the Federal Reserve already has more mandates than it can accomplish, and its mandates should be reduced, not increased.

As has been so vividly demonstrated in 2021 and 2022, the Fed cannot accurately forecast economic outcomes, and cannot know what the results of its own actions, or its “shots in the proverbial dark,” will be.

Meanwhile, it is painfully failing to provide its statutory mandate of stable prices. Note that the statute directs the goal of “stable prices,” not the much more waffly term the Fed has adopted, “price stability.” It has defined for itself that “price stability” means perpetual inflation at 2% per year.

The Fed cannot “manage the economy.” No one can.

And the Fed is obviously unable to guarantee financial stability. No one can do that, either. Moreover, by trying to promote stability, it can cause instability, an ironic Minskian result—Hyman Minsky was the insightful theorist of financial fragility who inspired the slogan, “stability creates instability.”

There are two things the Fed demonstrably does very well.

The first is financing the government. Financing the government of which it is a part is the real first mandate of all central banks, especially, but not only, during wars, going back to the foundation of the Bank of England in 1694. As the history of the Atlanta Fed puts it so clearly:

During the war [World War I], the Fed was introduced to a role that would become familiar…as the captive finance company of a U.S. Treasury with huge financing needs and a compelling desire for low rates.

This statement is remarkably candid: “the captive finance company of [the] U.S. Treasury.” True historically, true now, and why central banks are so valuable to governments.

The second thing the Fed does well is emergency funding in a crisis by creating new money as needed. This was its original principal purpose as expressed by the Federal Reserve Act of 1913: “to furnish an elastic currency,” as they called it then. This it can do with great success in financial crises, as shown most recently in 2020, and of course during wars, although not without subsequent costs.

However, the Fed is less good at turning off the emergency actions when the crisis is over. Its most egregious blunder in this respect in recent years was its continuing to stoke runaway house price inflation by buying hundreds of billions of dollars of mortgage securities, continuing up to the first quarter of 2022. This has severe inflationary consequences as the cost of shelter drives up the CPI and erodes the purchasing power of households. Moreover, it now appears the piper of house price inflation is exacting its payment, as higher mortgage rates are resulting in falling sales and by some accounts, the beginning of a housing recession.

Among the notions for expanding the Fed’s mandates, the worst of all is to turn the Fed into a government lending bank, which would allocate credit and make loans to constituencies favored by various politicians. As William McChesney Martin, the Fed Chairman 1951-1970, so rightly said when this perpetual bad idea was pushed by politicians in his day, it would “violate a fundamental principle of sound monetary policy, in that it would attempt to use the credit-creating powers of the central bank to subsidize programs benefitting special sectors of the economy.”

It is a natural and permanent temptation of politicians to want to do just that—to use the money printing power of the central bank to give money to their political supporters without the need for legislative approval or appropriation and to surreptitiously finance it by imposing an inflation tax without legislation.

One way to achieve this worst outcome would be to have the Fed issue a “central bank digital currency” (CBDC) that allows everybody to have a deposit account with the Fed, which might then become a deposit monopolist as well as a currency monopolist.

Should that happen, the Fed would by definition have to have assets to employ its vastly expanded deposit liabilities. What assets would those be? Well, loans and securities. The Fed would become a government lending bank.

The global experience with such government banks is that they naturally lend based on politics, which is exactly what the politicians want, with an inevitable bad ending.

On top of that, with a CBDC in our times of Big Data, the Fed could and probably in time would choose to know everybody’s personal financial business. This could and perhaps would be used to create an oppressive “social credit system” on the model of China which could control credit allocation, loans, and payments. Given the urge to power of any government and of its bureaucratic agencies, that outcome is certainly not beyond imagining, and is, in my view, likely.

The current push to expand the Fed’s mandates is consistent with Shull’s Paradox, which states that the more blunders the Fed makes, the more powers and prestige it gets. But we should be reducing the Fed’s powers and mandates, not increasing them. Specifically:

  • The Fed should not hold mortgage securities or mortgages of any kind. It should take its mortgage portfolio not just to a smaller size, but to zero. Zero was just where it was from 1914 to 2008 and where it should return.
  • The Fed should not engage in subsidizing political constituencies and the proposed politicized agenda should be scrapped.
  • Congress should definitively take away the Fed’s odd notion that the Fed can by itself, without Congressional approval, set a national inflation target and thereby commit the country and the world to perpetual inflation.
  • Congress should repeat its instruction to the Fed to pursue stable prices. As Paul Volcker wrote in his autobiography, “In the United States, we have had decades of good growth without inflation,” and “The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking.”
  • The Fed should be required to have sound accounting for its own financial statements, with no hiding losses in the former savings and loan style allowed. This requires taking away from the Fed the power to set its own accounting standards, which nobody else has.
  • The Fed should be prohibited from buying TIPS (Treasury Inflation-Protected Securities), because this allows it to manipulate apparent market inflation expectations.
  • The funding of the Consumer Financial Protection Bureau expenses out of Fed profits should be terminated. This is an indefensible use of the Fed to take away the power of the purse from Congress and to subsidize a political constituency. It would be especially appropriate to end this payment if the Fed is making big losses.
  • Finally, and most important of all, we must understand the inherent limitations of what the Federal Reserve can know and do. There is no mystique. We must expect it to make mistakes, and sometimes blunders, just like everybody else.

Knowing this, perhaps the 2020s will give us the opportunity to reverse Shull’s Paradox.

This paper is based on the author’s remarks at the American Enterprise Institute conference, “Is It Time to Rethink the Federal Reserve?” July 26, 2022.

*****

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