Thursday, May 16, 2013 - What's Next For the Fed

What's Next For the Fed

by Sinclair Noe

DOW – 42 = 15,233
SPX – 8 = 1650
NAS – 6 = 3465
10 YR YLD - .08 = 1.87%
OIL + .95 = 95.25
GOLD – 6.60 = 1386.90
SILV + .10 = 22.79

The Labor Department reports the consumer price index dropped 0.4% in April from March, the biggest monthly drop since December 2008. The main reason the index fell was that gas prices plunged 8.1 percent. Excluding the drop in fuel costs, prices were largely unchanged. For the 12 months that ended in April, overall prices rose 1.1 percent — the smallest year-over-year increase in 2½ years. Excluding volatile energy and food costs, “core” prices ticked up 0.1 percent last month. Core prices have risen only 1.7 percent in the past 12 months. That’s below the Federal Reserve’s 2 percent inflation target. Yesterday, we reported that wholesale prices declined last month.

Inflation is not the problem right now; it might be a problem at some point down the road, but not now.

John Williams, the San Francisco Fed president gave a speech in Portland and he indicated that the Fed's Quantitative Easing program can be reduced soon, and that the whole program may be halted this year. He pointed out the pace of job growth has picked up since the program was launched in September, with an average pace of job growth of 200,000 over the last six months.

Williams said: “Assuming my economic forecast holds true and various labor-market indicators continue to register appreciable improvement in coming months, we could reduce somewhat the pace of our securities purchases, perhaps as early as this summer. Then, if all goes as hoped, we could end the purchase program sometime late this year.”

Williams was open to the idea of ramping up bond purchases if the economy slows down.

So, let's go back to the Federal Reserve's dual mandate of price stability and maximum employment. Right now, prices are stable; even a little bit of disinflation based upon this week's producer-price index and consumer-price index. No need to taper off.

On the maximum employment side of the mandate, the Fed set a target of 6.5% unemployment, which is still a long way from it's mandate of maximum employment. One of the reasons the unemployment rate has dropped to 7.5% is because the participation rate has dropped; fewer people are considered to be in the labor pool. The economy has been adding about 200,000 jobs per month, on average, over the last six months. We know that many of those jobs are temp jobs; many are part-time jobs; many are lower paying jobs. But they are net new jobs. The problem is that 200,000 jobs is not enough to lower the unemployment rate, unless a lot more people fall out of the labor market.

This morning, the Department of Labor reported initial claims for unemployment increased 32,000 to 360,000.

So, why do we have all this talk of tapering off from QE?

In order for QE to work, rather than just inflate asset prices, there needs to be viable investment opportunities that create productive jobs in the short, medium, and long term. Infrastructure would qualify as filling the bill, but not just building bridges to nowhere. And this is the flawed premise of QE, according to a recent speech by Dallas Federal Reserve President Richard Fisher: “by driving rates to historical lows along the entire length of the yield curve, investors will rebalance their portfolios and reach out to riskier assets, providing the financial wherewithal for businesses to increase capital expenditures and reengage workers, expand payrolls and regenerate consumption. Rising prices of bonds, stocks and other financial instruments will bolster consumer confidence. The CliffsNotes account of this play has the widely heralded “wealth effect” paving the way for economic expansion, thus saving the day.”

Fisher went on to add: “Until job creators are properly incentivized by fiscal and regulatory policy to harness the cheap and abundant money we at the Fed have engineered, these funds will predominantly benefit those with the means to speculate, tilling the fields of finance for returns that are enabled by historically low rates but do not readily result in job expansion.”

There are a few problems here. Cheap money does not encourage speculation. Cheap money encourages prudent lending. If you can only get a small rate on your loan, you are more likely to make certain that loan will be repaid. This is why triple-A rated corporate bonds pay less than junk bonds. This is also why the residential housing mortgages written in the past two years are a much better vintage than the mortgages written in 2005. High rates encourage speculation. The risk is not in the low rates, but rather that the low rates push prudent potential lenders to seek higher returns elsewhere, like in the stock market.

The result, and it must be scaring the Fed, is that we are headed for a speculative bubble. If you always do what you've always done, you'll always get what you've always gotten. The Fed actually has some history with bubbles. The next time you read that a new era has dawned, that the old rules of economics don't apply, and that some asset class or other that’s been rising steadily for a while now is certain to keep on to infinity and beyond; that's just wrong. It really is that simple.  

The problem is that the Fed has been passing out cheap money to speculators and gamblers. And now they're shocked, shocked I tell you, to discover that the speculators are gambling with the cheap money. Speculation demands high rates as compensation for high risk, but the Fed has been passing out super-low rate money to the most high risk players.

And the banksters continue with their rotten ways. They take the zero-interest money from the Fed and they screw anybody and everybody they can. Today a case in point.

In 2006, Congress passed the Military Lending Act, which was designed to prevent predatory lenders from targeting men and women in uniform. But a new report from ProPublica and Marketplace entitled Beyond Payday Loans suggests aggressive lenders have merely shifted tactics and are still very actively going after military personnel.

Rather than a loophole, installment loan companies and so-called payday lenders have found huge gaps in the Military Lending Act. The Military Lending Act set a national interest rate cap of 36 percent APR (annual percentage rate) for loans to military members and their families (excluding mortgages and auto finance loans).

The Act covered three specific types of loans: payday loans (short-term, due in one lump sum after a borrower’s payroll check clears); car-title loans; and tax refund anticipation loans. Further, the loan-terms covered were restricted: 91 days or less for a payday loan, 181 days or less for a car-title loan.

As a result, lenders are offerings payday loans, which typically have annual percentage rates over 400%, with a duration of five months instead of three. Same is true of auto-title loans, which are secured by the vehicle’s title and typically have rates above 100%.

And yes it is the banksters that back the payday lenders, or in many cases the big banks are the payday lenders, through a different division of the company. QE and the other tools of the Fed have not cleaned up some of the worst abuses in the system.

Today, the International Monetary Fund weighed in, claiming the Quantitative Easing by the Fed, and the ECB, and the Bank of Japan had helped to stabilize financial markets and push asset prices higher. The IMF figured that: “While additional unconventional measures may be appropriate in some circumstances, there may be diminishing returns, and benefits will need to be balanced against potential costs.”

Maybe it is time to ask whether the Fed has been effective in its policy over the past five years. Yes, the Fed policy helped avert a global financial meltdown. Yes, the Fed policy prevented the collapse of the biggest banks. Yes, the Fed policy was a part in turning around massive job losses and helping bring down unemployment in a less-than-robust manner. No, the Fed hasn't done much to regulate the financial institutions that caused the problems in the first place. The Fed doesn't seem to believe in regulation; which is kind of like a Pope that doesn't believe in religion.

The Fed hasn't been particularly successful in its mandates. Perhaps the time is coming where they need to change the tools they're using. Maybe it is time to break away from Quantitative Easing, which mainly helps the banks, and maybe they need to start using tools that will promote a healthy economy, with maximum employment – not just a target of 6.5% unemployment – and help people find productive employment. And then they could use their regulatory tools to help ensure financial stability in what has become a casino market.

One of the better moves the Fed could consider is to open up low interest rates to entities other than the member banks; this probably exceeds the Feds generally accepted role, but not the technical limits of its tool box. Infrastructure investment still looks like the best, least speculative way to achieve the dual mandate. Imagine a country with a continental railroad - like what Lincoln did, or an nationwide highway system – like what Eisenhower did, or a country that develop science to the point we could fly to the moon – Kennedy and Johnson. Now imagine a country that is energy independent.

The time is coming for the Fed to move beyond Quantitative Easing, and this is why we've been hearing about tapering off. QE is not as effective as it once was, and it has never been as effective as it should have been. So, maybe a change is coming. The big question is where they go next.