Wednesday, March 19, 2014 - Behind the Curtain of the Mysterious Central Bankers

Behind the Curtain of the Mysterious Central Bankers

by Sinclair Noe

DOW – 114 = 16,222
SPX – 11 = 1860
NAS – 25 = 4307
10 YR YLD + .09 = 2.77%
OIL + .67 = 100.37
GOLD – 24.90 = 1331.60
SILV - .20 = 20.71

Sometimes the stock market is a grand mystery, a riddle wrapped in a mystery inside an enigma. Sometimes the stock market is simple. Wall Street loves it when the Federal Reserve is throwing bags of money out of the helicopter that hovers over Wall Street. The traders get a little nervous when it looks like the free money might stop raining down on them. That doesn’t mean the Fed is stopping throwing money at Wall Street, just that traders are nervous.

Today, the Fed FOMC wrapped up a two day meeting; they issued a statement; then Chairwoman Janet Yellen delivered a prepared statement; then she answered questions.

The Fed statement indicated the Fed could and likely would continue with its low interest rate policy even after they reach their goals of full employment and 2% inflation. The central bank proceeded with its well-telegraphed reductions to its massive bond-buying stimulus, announcing it would cut its monthly purchases of Treasuries and mortgage-backed securities to $55 billion from $65 billion per month.

I will now attempt to translate the Fed statement from Fedspeak to English. The statement said: the labor market is getting better but unemployment is still too high, household and business spending is decent but the housing market is weak, the politicians in Washington keep messing up the economy but they haven’t been adding on new mistakes lately so we should be able to work around them, inflation is too low and that might cause problems, even as they cut purchases to $25 billion a month in mortgage backed securities and $30 billion a month in Treasuries – that is still a heck of a lot of paper they are buying, the Fed analysts will keep an eye on economic conditions and at some point they will raise rates but not today and not based on a 6.5% target for unemployment, and the analysts think the economy is better than the  public thinks, and the only reason the economy is so bad is because the weather has just been horrible this winter.

Then, Janet Yellen held a press conference. Back in December the Fed forecasts called for unemployment falling to between 5.8% and 6.1% by the fourth quarter of 2015. The new forecasts show Fed officials see unemployment dropping slightly faster, to between 5.6% and 5.9% by the end of 2015. So, that ratchets up forward guidance on rates. Fed officials see slightly sharper increases than they did in December, with rates ending 2015 at 1% and ending 2016 at 2.25%, according to the median of forecasts. In December, Fed officials expected short-term rates to be just 1.75% by the end of 2016. Of course, that’s all dependent on economic data over the next year or more, and we could have another unexpected snowstorm or 2 or 20, but it was enough to make Wall Street traders nervous that the Federal Reserve won’t always provide a super low interest rate subsidy to the bankers.

The nervousness only grew as Yellen entered the Question and Answer phase of the press conference. She was asked how long the Fed would wait after the tapering ends before it begins to raise interest rates. She answered: “So the language that we used in the statement is ‘considerable period.’ So I, you know, this is the kind of term it’s hard to define. But, you know, probably means something on the order of around six months, that type of thing.”

So, let’s do the math. The Fed continues to taper asset purchases by $10 billion a month; announcing incremental cuts at each of the next 6 FOMC meetings; so maybe around October, they finish the buying; then 6 months pass and now we’re looking at April 2015, which is more or less when everybody knew the Fed might start to consider raising rates, if everything goes according to plan…, and we don’t have any more surprise snow storms.

And that is a big change for trying to figure out when the Fed will raise rates. It’s no more quantitative easing, based on a hard, quantitative number like 6.5% unemployment rate. Now the Wall Street traders actually have to look at the economy and try to guess the qualitative factors. Translation: the Fed is looking at when the economy improves, and the economy comprises a giant number of measures and statistics. If Wall Street wants Cliffs Notes, it will have to look elsewhere.

Interest rates matter to the Wall Street traders because it determines the profits for the Wall Street banks that trade Treasuries and mortgages and such, and they want the data spoon fed, kind of like the kid taking a test with an open book.

Part of the problem with the old 6.5% rule was that the unemployment rate didn’t do a good job of measuring the real employment picture; the unemployment rate was dropping, getting close to the 6.5% target, but that’s because more people were dropping out of the workforce. The unemployment rate only measures people who are still in the workforce and can’t find jobs; it ignores those who have given up.

Yellen just ended the “open book” testing. No longer will the Fed promise to raise interest rates at 6.5% unemployment. Instead, the Fed will raise interest rates when the economy is strong enough to justify it. Wall Street will have to actually pay more attention to the strength of the economy than they pay to filling out their basketball brackets.

Telling Wall Street traders to think is tricky business; they don’t think, they trade. The Fed, under Yellen, wants to keep market expectations aligned with their own forecasts. If traders start to price in earlier rate hikes, the result would be tighter financial conditions that could deter the very investment and hiring that the Fed wants to promote.

The only thing traders heard today was “around six months”. Did Yellen mean to be that specific? No, the Fed has always loosely defined “considerable period” as about half a year. It’s supposed to be a little vague. She probably didn’t intend to give any hints about timing beyond what the “dot plot” said. No Fed chair is going to confidently tell markets that it’s going to raise rates in 14 months. But now that she’s leading the Fed, the markets will react to what she said, not what she means. And this is where it gets interesting. Will Yellen and her Fed colleagues try to “walk back” her statements, or will they leave them out there as they stand. It could be a defining moment in the early stages of the Yellen-led Fed.

Meanwhile, there are some new definitions in on central banks role in the process of printing money, and that came from the Bank of England a few days ago. In a paper called “Money Creation in the Modern Economy”  co-authored by 3 economists on behalf of the  Bank of England, they state that most common assumptions of how banking works are simply wrong, and the entire theoretical basis for austerity is wrong.

Consider the old, conventional view, which continues to be the basis of most of the debate on public policy and the framework for austerity. People put their money in banks. Banks then lend that money out at interest – either to consumers, or to entrepreneurs willing to invest it in some profitable enterprise. True, the fractional reserve system does allow banks to lend out considerably more than they hold in reserve, and true, if savings don't suffice, private banks can seek to borrow more from the central bank.

The central bank can print as much money as it wishes. But it is also careful not to print too much. In fact, we are often told this is why independent central banks exist in the first place. If governments could print money themselves, they would surely put out too much of it, and the resulting inflation would throw the economy into chaos. Institutions such as the Bank of England or US Federal Reserve were created to carefully regulate the money supply to prevent inflation.

Under this old, conventional definition, money is a finite resource; there are limits. What the Bank of England admitted this week is that none of this is really true. To quote from its own initial summary: "Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits" … "In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money 'multiplied up' into more loans and deposits."

In other words, everything we know is not just wrong – it's backwards. When banks make loans, they create money. This is because money is really just an IOU. The role of the central bank is to preside over a legal order that effectively grants banks the exclusive right to create IOUs of a certain kind, ones that the government will recognize as legal tender by its willingness to accept them in payment of taxes. There's really no limit on how much banks could create, provided they can find someone willing to borrow it.

What this means is that the real limit on the amount of money in circulation is not how much the central bank is willing to lend, but how much government, firms, and ordinary citizens, are willing to borrow. Government spending is the main driver in all this. So, there's no question of public spending "crowding out" private investment. It's exactly the opposite.

Some of us have known this for quite some time, but this was the first time a major central bank has admitted it. Why did they admit it? Probably because that whole austerity thing hasn’t been working out.