Fox Business reports about Plosser's comments on inflation and the Fed.
(emphasis mine) [my comment]
July 27, 2009 3:47PM
A Fed Inflation Hawk Speaks
By Elizabeth MacDonald
"I think we will probably have to begin raising rates sometime in the not-too-distant future," Federal Reserve Bank of Philadelphia President Charles Plosser told Dow Jones Newswires and the Wall Street Journal in an interview.
A renowned inflation hawk at the Federal Reserve is at it again, trying to pull more dovish Fed officials under his wingspan of influence to get them to do more to battle incipient inflation.
And the timing of Plosser's comment is interesting, notes Charles Brady, senior editor of the Fox Business Network.
The Fed is selling [on treasury's behalf] a record amount of weekly debt, $115 billion now coming up, a sum that tops the previous weekly record of $104 billion set just last month. The bond glut pushes yields higher because so many bonds means a lot of competition, which means the Treasury has to offer enticing, come-hither yields to lure investors in.
"The impending glut of supply has been pushing Treasury yields higher," says Brady. "What better way to try and keep a lid on rates ahead of this debt sale than to have a Fed official say that policy makers are likely to begin raising rates sooner rather than later."
Plosser has been notably direct in saying that inflation must be higher on the Fed's list of priorities.
For one, the US central bank's gross exposure to the bailout programs is $6.8 trillion out of the government's potential $23.7 trillion. Because it's difficult to pull monetary levers when rates are effectively at zero, the Fed under chairman Ben Bernanke has made a quantum leap in its balance sheet, and the markets fear Fed officials cannot stop this science project from exploding into inflation.
Put it into perspective. One trillion is now the new billion, analysts say. A trillion is greater than the GDP of Australia, $1 tn is enough to buy the Toronto stock exchange, it is twice the cost of FDR's New Deal, and $1 tn could buy every home foreclosed in 2007 and 2008, estimates show.
And now, the bond market is bracing for $2 tn in government debt issuances within the next 12 months to pay for the government's spending programs, the $787 bn stimulus package and the $3.6 tn budget.
"If you sell it, they will come, is the US Treasury's Field of Dreams," quips Peter Boockvar, an extremely sharp, smart Wall Street analyst with a big following at Miller Tabak, where he is a managing director and equity strategist.
Boockvar adds that most of this debt should be easy to sell as most of the bonds have maturities of five years and less. [I disagree. The return of inflation is likely to coincide with a steep selloff of short dated treasuries.]
But he adds that "if the stock market is right and the economy in the second half of the year will have a strong rebound, then interest rates are going higher due to higher inflation and the demand on the part of foreigners, who own half our debt, and others for higher yields for the enticement of buying the enormous new supply."
The Goldilocks economy of strong growth and low inflation was 1990's fiction, Boockvar says. Unless, of course, gridlock over health reform in a rampantly reckless Washington might now create the new Goldilocks economy, jokes economist Ed Yardeni.
Boockvar notes that all of this spending is starting to sting the US dollar, which is now falling to just shy of its lowest level since December 2008 versus the euro.
And listen to what Richard Bernstein, Merrill Lynch's former chief investment strategist, is now saying, that America still blowing bubbles. The US government in a post-bubble environment simply is genetically incapable of waiting for economic growth to rebound to soak up excesses, and instead reflexively acts without thinking in the face of growing voter unease over job losses.
So the US has now embarked on Japan's post-bubble strategy, which it did during the 1990s, that is, to support excess capacity by reflating the economy via gunning the mints, moves which stymie the post-bubble consolidation forces, Bernstein notes.
Easy money is like tequila, tasty, but dangerous, another inflation hawk, Dallas Fed official Richard Fisher, has warned.
Bloomberg reports that tightening credit becomes Bernanke bind in bond purchase unwind.
Tightening Credit Becomes Bernanke Bind in Bond Purchase Unwind
By Yalman Onaran
July 24 (Bloomberg) -- Now that the U.S. economy shows tentative signs of recovery, James Bullard, president of the Federal Reserve Bank of St. Louis, wants the Fed to adopt a plan for taming the inflation he expects may follow the end of the recession. Unless the central bank puts a strategy in place and presents it to the public, inflation expectations may run rampant, Bullard says.
He's pessimistic such a plan will be forthcoming. "I think I'm an army of one on that," Bullard said in an interview after a speech in Philadelphia on June 30.
The Fed always faces a hard choice as recessions run their course (this one began in December 2007): It can keep pushing to revive growth and avoid deflation -- an extended drop in prices like the one that devastated the U.S. economy in the early 1930s -- or it can take aim at inflation and risk strangling the recovery before it takes hold.
The unprecedented steps the central bank has taken to battle the credit crunch, especially its purchases of mortgage- backed securities, pose an inflation risk that's trickier than in previous recessions, says Joseph Mason, a banking professor at Louisiana State University in Baton Rouge, Louisiana.
Don't count on the Fed to get it right, says economist Allan Meltzer of Carnegie Mellon University in Pitt sburgh. The central bank has often lacked the resolve to pursue unpopular policies to keep prices in check, says Meltzer, who's the author of two volumes chronicling the Fed from 1913 to 1986.
"The Fed throughout its history has carried out a strategy of taking care of today's problems, not looking to the future," Meltzer says.
So far, inflation has shown no signs of heating up -- nor has deflation reared its head. The U.S. core inflation rate, which excludes food and energy costs, fell to 1.7 percent as of June from 2.4 percent at the beginning of the recession. In the Great Depression, consumer prices fell for more than three years, at an annual pace as high as 10 percent.
Federal Reserve Chairman Ben S. Bernanke, who has published academic research on the Depression's causes, is wary. He said in June that the Fed continues to watch for deflation, and he testified to Congress this week that the economy still needs support to recover, especially in light of rising unemployment. The central bank has the tools it needs to reverse its monetary easing when it's time to fight inflation, he said.
Among the Fed governors and reserve bank presidents who oversee monetary policy, most see slow growth and deflation as a bigger risk than inflation, based on speeches they have delivered in recent months.
Fed Balance Sheet
Bullard, among the minority worrying more about inflation, says the real risk is simmering on the central bank's balance sheet. By making loans and buying securities to unfreeze the credit markets, the Fed has doubled its balance sheet assets to $2 trillion in the past year.
About half of that expansion came through short-term lending to financial institutions. The Fed is scaling back those facilities. It's the rest of the balance sheet growth that concerns Bullard -- especially $661 billion of MBSs acquired to push down rates on home loans. The Fed has said it may buy as much as $589 billion more.
"I call those the politically toxic assets," says Benn Steil, a senior fellow at the Council on Foreign Relations in New York. Selling those bonds would boost home buyers' borrowing costs and stall the recovery of the housing market.
Traditionally, the work of a central banker has been simpler: lower your benchmark rate to counter a recession and raise it when the economy recovers to prevent inflation. The current crisis shows the limits of that approach. Even after the U.S. federal funds rate was cut to zero late last year, the economic slide worsened. U.S. gross domestic product fell at a 5.5 percent annual rate in the first quarter of 2009. Bernanke responded with the loans and the purchases of MBSs, an approach known as quantitative easing.
One way to counteract the easy credit the Fed has created might be to raise the interest rate on the reserves that lenders hold at the central bank, Bernanke says. U.S. financial institutions had $781 billion of such reserves as of this week, up from just $32 billion in September 2008. The central bank got authority in October to pay interest on those funds. It has been paying 0.25 percent and can change the rate at any time.
Banks will withdraw this money when they feel it's safe and profitable to make loans. By paying higher interest, the Fed would make it less attractive for banks to pull that money out and pump it into the economy.
There's little precedent for managing the money supply with interest on reserves, so it may be impossible to figure out where to set the rates. "We don't know what a percentage point change in the interest rate on reserves will do to lending by banks," says Mason at Louisiana State.
Meltzer is skeptical that Fed policy makers will act, even if they figure out how. In the 1960s and 1970s when inflation was rising, the Fed set out goals to fight it at least four times only to back down under political pressure. Paul Volcker, who became Fed chairman in 1979, was the exception. He ignored politicians and pushed the benchmark fed funds rate as high as 20 percent in the early 1980s.
Central bankers tilt toward stimulating growth, Meltzer says, partly because Depression-era deflation is imprinted on their minds, while periods of deflation prior to the 1930s that didn't wreak havoc are forgotten.
The perception that a central bank won't move against rising prices can actually contribute to inflation, says William Silber, a professor at New York University. When the public expects inflation, it's easier for retailers to raise prices and for workers to demand wage increases, he says.
Silber is writing a book about Volcker's fight against inflation in the 1970s, when prices rose even during recessions. The public's view that there was a lack of will to fight inflation helped cause this phenomenon, known as stagflation.
This is one reason Bullard wants the Fed to actually publish a plan for tackling inflation and not just draft it for internal purposes. To contain inflation, the battle often needs to begin before it's visible -- never a politically pleasant task. Acting now promises to be especially unpalatable, with unemployment at 9.5 percent in June and home foreclosures coming at a record pace in the first half of this year.
My reaction: Instead rehashing the skepticism in the two articles above, I want to take a look at the Fed's growing financial liabilities and its deteriorating asset quality.
The Fed's growing financial liabilities
Now that the Fed has started paying interest on reserves, balances held at the Fed should be regarded ultra-short-term, variable-interest-rate US debt. These short term financial liabilities hit a new high this week of 951 Billion.
By paying higher yield than the one month Treasury despite the shorter maturity, the Fed is overpaying interest on bank reserve balances.
Look at the yield curve below. Notice that:
1) The shorter the maturity, the lower the interest rate. The exception to this is the interest paid on reserves by the fed, which has a daily maturity and pays more than one month and three months treasuries.
2) One month treasuries were trading at around 3 percent in January 2008. When inflation starts picking up, the fed will need raise interest paid on its reserve to above 3 percent to keep up with one month treasury yields. The difference between paying .25 percent and 3 percent on 951 billion dollars is huge.
The Fed's deteriorating asset quality
The screenshot of the Fed's balance sheet shown below illustrates the Fed's problem of unsellable assets. The blue circle represents assets which could be sold to shrink the money supply and loans to foreign central banks which are being repaid. The red X represent loans to insolvent financial institutions (which means loans can't be called in) collateralized by toxic 'AAA' securities (which are virtually worthless).
The Fed's deteriorating asset quality
Liberty Grotto looks at asset sales from Federal Reserve holdings in terms of the asset quality.
...I want to focus more on the last item above (#5) [Asset sales from Federal Reserve holdings] as it is not being discussed in terms of the quality of assets being held by the Fed [Agreed]. The assumption has been that the Fed will be able to drain all (or most) of the reserves it originally created [impossible]. But since the Fed is going further out on the yield curve with treasuries, it is more susceptible to interest rate risk. If the Fed were to drain reserves by selling these longer term treasury assets (which would also put upward pressure on interest rates), the price that these assets would fetch would quite likely not be enough to drain the amount of reserves originally created when it purchased them. Also as I have previously discussed, the composition of the balance sheet is getting shakier. I think that this may ultimately be the larger problem, as opposed to the sheer size [100% Agreed]. This may become a serious problem as MBSs, longer term treasuries, and other assets held by the Fed decline in value relative to their inflated purchase price (especially as the Fed commences the selling of these assets and interest rates rise). In other words, simply the Fed saying that it will execute a proper exit strategy (draining the reserves it created) is not enough with the prices of their assets falling [exactly]. Meanwhile, much more debt remains to be auctioned (both domestically and globally). There will be much competition for scarce funds globally, which will place upward pressure on interest rates [been warning about this]. Thus, the Fed will likely find itself in a position where the assets it holds are falling in price while it needs to assist the Treasury market by purchasing treasury debt ... which will add reserves to the banking system making a successful execution of the Fed exit strategy even more difficult [more like impossible]. I think that eventually, another option may surface, but will require congressional approval. I have discussed it in prior missives ... the issuance of Federal Reserve interest bearing debt (which would compete with Treasury debt). [The issuance of Federal Reserve interest bearing debt isn't a valid option because precisely this debt would compete with treasury debt.]
US Monetary Base VS Sellable/Safe Assets Held By FED
The graphic below shows the distribution by maturity of Treasury Securities held by the Fed in December 2007 and July 2009. It is clear that the average maturity of treasuries on the Fed's balance sheet has changed drastically.
Conclusion: The Fed has no workable exit strategy. The US is about to enter a period of stag(hyper)inflation worst then anything experienced in over a hundred years.