Wednesday, September 19, 2012 - Distortions and Unintended Consequences

Distortions and Unintended Consequences

by Sinclair Noe

DOW + 13 = 13, 577
SPX + 1 = 1461
NAS + 4 = 3182
10 YR YLD - .03 = 1.78%
OIL – 3.31 = 91.98
GOLD – 1.40 = 1770.70
SILV - .21 = 34.67
PLAT + 12.00 = 1647.00

It was no surprise last week when the Fed announced a new quantitative easing (QE) program. They had telegraphed the new QE. The Fed will purchase $40 billion of agency and mortgage-backed securities (MBS) per month until the labor market improves. This amounts to about half a trillion dollars per year, give or take a few billion, and there is no specific limit on how long the program will last. Toss in $85 billion a month in the still-in-effect Operation Twist and by 2015, the Fed balance sheet would grow to $4 trillion, from under $3 trillion today.

And the European Central Bank is on the path of its own quantitative easing via open-end bond buying like our own Federal Reserve. Some Euro countries are in a flat out depression and even the healthy ones are looking at economic contraction at least through the end of the year, with GDP forecast in the range of negative -0.6% to -0.2%.

Now, the Bank of Japan has joined the party, announcing their own bond buying program, hoping to avoid the appearance of a strong currency, or maybe to stimulate economic growth. I don't know anymore. Pick a reason that suits you. I suspect, the central bankers are doing a big favor for the big banks, and that the balance sheets of the big banks are far uglier than most people might suspect. The Peoples' Bank of China is probably the next to join the party.

I guess it's just business as usual. The Fed keeps rates low to avoid the government going bust, which would happen if it had to pay too much interest on its debt. The Fed has essentially promised to destroy the dollar to keep supporting the banks and to keep the government alive, with debts that the political parties have no way of coming to an agreement on how to fix. And the situation is global and the response has been coordinated. No surprise. The Fed has clearly told us what to expect. At some point it might become a surprise, but for now, it doesn't pay to fight the Fed.

So, the Fed is going to add liquidity, which is another way of saying they will print more dollars, which means it will take more dollars to buy many things, such as commodities. When traders think the dollar's in trouble their first instinct is to trade commodities. Suddenly a bid is put in for silver, gold, oil, copper, natural gas; basically anything bought and sold in International markets makes sense when the greenback is in peril. Nothing goes up in a straight line, but a funny thing is happening in the oil markets; the price is dropping. We're not talking about a little consolidation. The price is dropping; down 3.31 at 91.98. The global economy is slowing down and that tends to push oil prices lower because people use less energy in their businesses. Crude inventories increased much more than expected last week, 8.4% higher than a year ago. The refineries closed for Hurricane Isaac are getting back online. Saudi Arabia is keeping production high to push oil prices lower. The Fed announces QE3; risk on; oil prices drop. Go figure.

A new survey from the American Payroll Association shows 68% of Americans are living paycheck to paycheck; they say it would be somewhat difficult or very difficult if their paychecks were delayed for one week. The good news is that in 2010 there were 72% of respondents who were living hand to mouth. Yea, it's kind of scary.

So, this should remind us that policy intervention needs to point directly to the problem, because the further away and more indirect the policy intervention, the more likely that other distortions and unwanted effects will occur. We can make some informed decisions based upon general information and past performance; for example we can fall back on the old adage “don't fight the Fed”; I think it's a pretty safe bet that gold is going back to old highs and probably higher; and since the Fed is jumping in with a half trillion per year in MBS purchases, it's probably a safe bet that mortgage rates are going to stay very low for a while; and I think it's a safe bet there will be distortions and some strange twists along the way.

These bond buying operations lower the respective currency relative to other currencies and tend to lift equity and commodity prices in the short term as the additional liquidity finds a new home. The overall outcome of these side effects is inflationary pressures in food and energy that potentially decreases consumption and therefore reduces overall economic activity.

What you may have also noticed about these programs is that it is possible that there is no overall direct effect on the public. Unless a household or business themselves happen to be a holder of a particular type of financial asset then the public doesn’t actually receive any of this money. In the case where a bank is the owner of an asset all that occurs is an asset swap which creates excess reserves in the banking system. That is, in either case the major outcome of these policies is simply a change in composition of the asset side of commercial bank’s balance sheets. For households and businesses the real outcome is potentially interest rates are lower than they otherwise might be.

Bernanke has used the depressed state of the US economy to justify QE, but the monetary expansion could have been achieved by purchasing government assets rather than buying mortgage backed securities. It is also a bit odd that a federal agency proposes to fine-tune the housing sector even though there has been no movement to clean up the banks that have abused the housing market.

Today, a law firm that won an $8.5 billion settlement from Bank of America tied to faulty mortgage bonds is going after Wells Fargo and Morgan Stanley for failure to service $73 billion in residential mortgage backed securities. While Bank of America’s deal is awaiting court approval, attorneys general from New York and Delaware have intervened for more information. New York has said there are serious questions about the fairness and adequacy of the accord, which covers a small fraction of the losses, which by some estimates were closer to $420 billion.

And this is the sector the Fed is pumping up.

And while the Fed's balance sheet grows to astronomical proportions we should wonder if the Fed isn't creating a new bubble. Is there reason to believe that another venture into developing the housing sector will be more successful than the last one? If the economy recovers, and it is time for the Fed to reverse the monetary expansion, how anxious will the Fed be to sell mortgage-backed securities and slow housing expansion? Who buys all those mortgage backed securities? At what price? In the US it has been far easier to add subsidies to housing than to withdraw them. For example, look at the now untouchable mortgage interest rate deduction.

So anyway, the idea is to get households and businesses to borrow more money from commercial banks and spend their savings in the economy; the money moves around, the velocity increases and – voila – an economic recovery. But fiscal policy continues to lower private sector wealth, at least for most people (who are living paycheck to paycheck), and in turn there is a reduction in demand for credit, which in turn is further weakening the economy. And the weaker economy offsets any monetary expansion program. It’s a little like Sisyphus rolling the boulder up the hill.

And the idea of open-ended Fed intervention is a little scary. How far will they have to go? Congress procrastinates on fiscal policy while simultaneously demanding more and more drastic action from the Fed. So Bernanke tries to pound nails with a handsaw; without the aid of fiscal policy, he tries to drive down unemployment by pumping up the housing sector, which is the long and winding path of policy intervention, and we know that indirect path leads to distortions and some funny unintended consequences.