The Fed Giveth, And The Fed Taketh Away

Central bankers are master counterfeiters. Counterfeiting is morally wrong. It is also economically wrong. But this is the world we live in. Many think that these people are in control and can micromanage trillions of individual decisions by printing money and issuing incomprehensible press releases. Like a pyromaniac that sets things on fire and comes to the rescue, they are now called “the committee to save the world”. Some committee.

The Federal Reserve balance sheet went from $900B in 2008 to $4T today. You know, it helps when you can print money to save a couple of banks—sorry, the world. Now the Fed stopped printing. The Fed used to buy $85B worth of bonds each month and it stopped in October 2014. What’s next? There’s a lag for sure but usually the roosters come home to roost as we saw recently in 2002 and in 2008. Like Franklin Sanders used to say, central bankers know two things: inflate and blarney. Let’s look at the blarney. Inflate will be back soon enough.

So The Fed Will Raise Rates?

For some time now, all we’ve heard in the financial and business news is that the Fed will raise rates soon. June 2015? September 2015? The problem is that nobody explains how the Fed can raise rates. Which rates? The Federal Reserve controls the funds rate (the overnight lending rate between the banks) but banks have $2T in excess reserves at the Fed. The latter pays the banks 0.25% to keep excess reserves in the equivalent of a digital vault. The banks prefer to put their money there than to lend into the real economy; this is saying something about their trust in the “recovery” since 2008. The Fed can raise the rate of interest paid on excess reserves from say 0.25% to 1% and banks will most probably put more of their money at the Fed instead of into new businesses. Why would the Fed do that? It will have to take this money from somewhere; it will be from the money that goes normally to the Treasury. The deficit will go up as a result.

The Fed is not buying bonds or other assets right now so it doesn’t control long-term rates. The 90-day T-bills are close to zero and the 30-years bond is under 3%. People are happy to lend their money at these rates to the US government and the latter is happy to be able to run massive deficits at practically zero interest. This is nirvana for the US government.

The Fed could sell bonds but again why would the Fed do this? It would force the mortgage rates and the deficit back up. For now, the stock market is rising, bonds sellers are happy. What’s not to like? It has actually engineered quite a stunt by printing all that money and producing what one would expect to be double-digit inflation in consumer goods (assets are another story – more below). The $2T in excess reserves is keeping the economy from going into mass inflation.

Also note that the inverted yield curve used to be a good indicator for recessions but short-term rates in the US are already to the floor. In Canada, the yield curve inverted in January of this year. The Canadian oil bust is very real as was acknowledged by the recent Bank of Canada rate cuts. Rates are already low. How will a tiny percentage point lower help already distressed commodity producers, oil producers, China, Europe?

Mal-investment Champions - Bubbles Pop Eventually…

The shale oil boom is a good example of Mortgage Crisis 2.0. The price of a barrel of oil has been cut in half since June 2014. But we forget that it was $35 a barrel in March 2009. Fed policy (in concert with other central bankers) of zero interest policy (ZIRP) helped fuel the shale oil bubble. Yield-hungry investors borrowed cheaply and lent to oil companies. The companies raised money via IPOs, MLPs (Master Limited Partnerships) and borrowed from banks to re-package deals into securities to sell to other “late to the party” investors. Companies and nations like Saudi Arabia did not stop ongoing production to restrict supply and get prices up; they have bills to pay. But new projects are being put on hold for a while.

This is what happens when prices go against a highly leveraged industry. This is tough for oil companies that made bad decisions based on free money but cheap oil is good for consumers. At low prices, more will be demanded. Like it was not the end of houses, it is not the end of oil but one would like to avoid the steep rollercoaster ride caused by free money.

Now if you think the US is the king money printer, well, move over America, here is China. Many thought China would be the beacon of hope in 2008, taking the slack for the recession in the US and Europe. Taking the slack they did. If a picture is worth a thousand words, as the Financial Times reported last year, according to historical data from the US Geological Survey and China’s National Bureau of Statistics, during the two-year period 2011-2012 (which was the peak of China’s response to the Great Recession), China consumed more cement than did the United States during the entire 20th century! Think about that for a minute.

China is the world champion ponzi economy and mal-investment of real resources of all time. This is a country that thinks it is brilliant to build cities for millions of people when nobody moves in. Now we are seeing again prices moving against this uber-leveraged building industry. The commodity sector is feeling the heat as prices have collapsed. China has tons of overcapacity in steel production, cement, copper, iron ore, etc. And they have piled up tons of this stuff as “collateral” to add more loans. The People’s Printing Press of China can print all the Yuan it wants and lower reserve requirement ratios to sub-atomic levels; this thing will go down at some point. They will not escape economic laws but for sure they will try to fight it.

Stock Market: Last Man Standing

Even in the face of some recent less-than-stellar economic news, the stock market keeps on trucking. Even without its immediate monetary juice. There is a reason for that. If we go back to the relationship between monetary supply and prices, when we have a money surplus, people want to get rid of it, they exchange money for goods. The adjusting mechanism is that prices go up to eliminate the surplus. This process doesn’t affect all markets in the same way. For the stock market, the relationship between prices and money supply has a time lag because there are earlier recipients and later recipients of the money. You can go back to the crashes of 1929, 1987, 2002 or 2009 to see that there is a lag between peak liquidity and peak stock market of a couple of months to some two or three years, but always, when the money liquidity stabilization dominates, a stock market downturn is in the cards ahead. You can have a look at this interesting chart from Frank Shostak (http://mises.org/library/how-easy-money-drives-stock-market).

The FED giveth, and the FED taketh away.

Marie-Josée Loiselle, BEcon, MPA, President, MJ Economics,Montreal, QC (514) 574-6641, mariejo@mj-economics.com,www.mj-economics.com