The Fed's Next Moves

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Bernanke and
the Federal
Open Market Committee
are now paying the price of their tight-money
policies that began the month that Bernanke became FED chairman:
February, 2006. He inherited the boom and bubbles that Alan Greenspan’s
expansionist monetary policy had created. This expansion began in
mid-August, 1982, under Paul Volcker, and accelerated in the month
Greenspan took over: October, 1987. With stop-and-go policies to
restrain price inflation, Greenspan concealed the irreversible direction
of an 18-year era of loose monetary policy.

After June,
2000, the FED began lowering the target rate for federal funds,
the rate at which banks lend money to each other overnight. It fell
from 6.5% to 1% in 2003. Then, slowly, it was raised back up. When
Greenspan left office, on January 31, 2006, it stood at 4.5%.

this is a target rate. It is the rate, when breached by the actual
free market FedFunds rate, at which the FED will intervene and buy
a financial asset with newly created money, thereby lowering the
FedFunds rate. This intervention reassures bankers that the FED
will honor its target rate.

This happened
on August 3, when the high for the day hit 6.5%. This was not its
high in recent months. It hit 7% twice in June and twice in July.
In each case, the FED intervened, and the rate dropped to 5.25%
or slightly above — maybe a hundredth of a percentage point above.

The FED intervened
immediately on August 3, as before, and by the end of the day, the
market rate was 5.24%, a fraction of a point under the target rate.
It hit 6% again on August 7. The FED knocked it down to 5.27%, which
was slightly above the target rate. The next day, it went to 6.05%,
and the FED knocked it down to 4.68%. And so on, every day, ever
since. The free market FedFunds rate has been above the target rate
every day, inter-day, and the FED has knocked it back down before
the end of the day. You
can monitor this here.

So, what we
see in recent months is that the market rate has been pushing through
the target rate, exceeding it inter-day. Then the FED knocks it

This has led
to an increase in the adjusted monetary base since the first week
of July. The
chart is here.

This is not
proof of a great reversal of the FED back to inflation, but it is
consistent with such a move.


The FedFunds
rate under normal times remains under the target rate all day long.
The market does not get a full percentage point above the target
rate, inter-day. Yet it did twice in June and twice in July.

That should
have tipped off stock market investors that a problem was brewing.
Money was getting tight. Banks were not meeting their reserve requirements,
and were forced to borrow.

I told my Website
subscribers on June 23 that I thought the stock market was close
to a peak, but it took until July 19 for this peak to occur. There
was a euphoria that blinded investors’ eyes to problems brewing
regarding bank liquidity.

Stock market
investors respond to symbolic announcements. When the stock market
is toppy, the symbols that investors respond to most are changes
in the FED’s announced rates. In most situations, this is the FedFunds
rate. In rare instances, it is the discount rate, the rate at which
the FED loans money directly to banks. Usually, this is kept a percentage
point above the target FedFunds rate.

On August 17,
the FED announced a cut in the discount rate from 6.25% to 5.75%.
This is very rare: a half-point spread between the FedFunds target
rate and the discount rate. The Dow Jones Industrial Average rose
early by 300 points, then fell by 200, and closed up for the day
by 233.

Five days later,
on August 22, four major money center banks borrowed $500 million
each: Citigroup, J. P. Morgan Chase, Bank of America, and Wachovia.
These are the four largest banks in the United States.

This was very
peculiar. First, this market is usually under $100 million. Second,
the FED has a policy of not revealing which banks have borrowed.
Third, the announcement came independently from the four banks.
Fourth, all of them borrowed exactly $500 million. Deutsche Bank
AG also borrowed, but it did not say how much.

Let’s review:
the four largest U.S. banks on the same day borrow the same amount
of money and go public with this information when they are not required
to. This was not collusion. Not at all. Nobody who doesn’t want
a lawsuit would say it was. It was just one of those things, just
one of those crazy things.

Wall Street Journal offered this interpretation:

The move
is widely viewed as symbolic, since all of the banks borrowing
from the central bank can obtain less-expensive funds elsewhere.
But one Fed goal is to remove the traditional stigma attached
to borrowing from the discount window so that more banks may feel
comfortable borrowing. Historically, the discount window has been
where banks borrow when they’re unable to borrow anywhere else.

But, so far,
these large banks appear to be the only ones that have tapped the
discount window, with its above-market rate of 5.75%, when money
can be obtained at 5.25% through the FedFunds market.

On August 24,
that on August 20, the Federal Reserve temporarily
exempted Citigroup and Bank of America from restrictions on these
banks’ lending money to their brokerage divisions. The article also
said that this exemption had been granted by letter on August 20.

Then they both
borrowed $500 million on August 22.

It was just
one of those things, just one of those crazy things.

But what does
this exemption mean? The article’s author thinks it means there
is a liquidity crisis.

The regulations
in question effectively limit a bank’s funding exposure to an
affiliate to 10% of the bank’s capital. But the Fed has allowed
Citibank and Bank of America to blow through that level. Citigroup
and Bank of America are able to lend up to $25 billion apiece
under this exemption, according to the Fed. If Citibank used the
full amount, "that represents about 30% of Citibank’s total
regulatory capital, which is no small exemption," says Charlie
Peabody, banks analyst at Portales Partners.

The Fed says
that it made the exemption in the public interest, because it
allows Citibank to get liquidity to the brokerage in "the
most rapid and cost-effective manner possible."

On the day
this information appeared, the Dow rose 145 points. Investors thought
this was all great news. I think it reveals panic at the FED, which
in turn is based on panic at the money center banks.


what the FED will do is like reading tea leaves.

But let me
give it a try.

The FED doesn’t
want to send a message of panic, so it will not lower the FedFunds
target rate until its next scheduled meeting, which is September
18. At that meeting, it will announce a rate cut. The FED will cut
it by at least .25 percentage point. But to be sure that bankers
know the FED means business, I think it will be .50 percentage point,
matching the cut in the discount window’s rate.

This will be
heralded by the financial media as a sign that it’s time to buy
stocks. The increase from 1% in 2003 to 5.25% in 2006 was also seen
as a signal to buy stocks. Everything is the media’s signal to buy

The FED has
another problem to deal with: lack of information on the condition
of the banks’ business loans. Are borrowers in good shape to repay?
This is the issue of looming corporate insolvency, which is the
result of the liquidity problem in this, the early stage of a contraction
in the economy.

So, I think
the announcement of a half point cut in the FedFunds target rate
will be accompanied by new requirements on reporting to the FED.
This will be the FED’s quid pro quo for providing new banking reserves.

Here are the
FED’s two problems. First, the FED for three months has been battling
to keep the FedFunds market rate at 5.25%. To do this, it has had
to increase its holdings of debt. This is inflationary. If it pushes
the target down to 4.75%, then it will have to add reserves even
faster than it is adding them today.

Second, the
FED cannot examine every business account in every bank. It must
sample a few big-name banks’ largest clients, whose faltering would
present a problem for the money center banks. The FED cannot examine
every small bank’s client base.

The FED must
send a two-fold message: "We are on top of things. We are making
available liquidity to protect the capital markets in a time of
needless volatility and fear. We are also making sure that there
are no surprises in the corporate sector."

As Franklin
Sanders says, the FED has only two tools: inflation and blarney.
They will use both on September 18.

This assumes
the FED can wait until September 18. If things get really dicey
between now and then, the FED will have to cut the rate early. This
will create uncertainty about the extent of the crisis. The FED’s
fiat money is always welcome, but the FED must not be perceived
as running around like a chicken with its head cut off.


The yield curve
is the drawn shape of interest rates for Treasury debt from one
month to 30 years. I think the 90-day/30-year rates are most significant,
but others prefer 90-day/10-year. Under normal times, the 90-day
rate is below the longer rates.

On August 20,
the rate for 90-day T-bills fell from 3.76% on August 19 to 3.12%
This indicated investors’ near-panic move to safety. It was on this
day that the FED sent out the letter authorizing Citigroup and Bank
of America to lend money to support their equity funds.

The next day,
August 21, the rate went up sharply to 3.59%, indicating that the
panic had subsided. On August 23, the day before the story of the
Citigroup/Bank of America exemption was released, the rate was 3.89%.
On the day it was released, the rate went to 4.24%. The Dow rose
145 points.

the 30-year T-bond rate fell. It was at 4.98% on August 20. The
next day, it fell to 4.95%. On August 24, it was at 4.88%. This
indicates a move into long-term debt. Why would an investor do this?
In order to lock in a rate for 30 years. This is a move toward recession-protection
and away from inflation-protection.

Yet the money
supply is increasing. Won’t long rates go up? Yes, but not in a
straight line if investors at the margin see recession as the major
threat. Long rates will fall, then rise.

Stock market
investors grew bullish on the economy on August 24. Bond buyers
grew bearish on the economy on the same day. I think the bond buyers
were correct.

I remain bearish
on the economy, but I also recognize that stock market investors
respond to symbolic moves by the FED. They see fiat money as good
for the economy. They think the FED can overcome a looming recession.
The war between bulls and bears will continue. I think the bears
will win it over the next six months.

While the FED
is now pumping in new reserves at a little under 6% per annum, and
I expect it to continue this policy for the foreseeable future,
I don’t think this will be enough to reverse the sagging economy
in the next six months. But if I am wrong, then we can expect a
return of accelerating price inflation.


I think the
FED has reversed course. The comparatively tight-money policy it
followed from February, 2006 to late June, 2007, is a thing of the
past. Preliminary signs of the recession predicted by Austrian economic
theory became visible in the capital markets: first, with respect
to new home builders, then with respect to the inverted yield curve,
then with daily upward breaches in the Federal Funds rate, then
with a falling stock market.

I do not believe
the FED can withstand pressures from money center banks to inflate
or die. It hasn’t resisted since about 1938. I see no reason to
believe that it will again reverse course and allow a major credit
crisis. "Too big to fail" is still the FED’s mantra. It
is also Congress’ mantra.

its relatively tight-money policy was nice while it lasted, but
it looks as though the economy’s days without the punchbowl have
ended. Of course, I hope I am wrong. The economy needs stable money.
But the price is a move into recession and the bursting of the housing
bubble. Politically, this is a price the FED is unwilling to pay.
It would generate too much pressure from incumbent politicians in

The FED’s #1
function is to save the money center banks. It has surely taken
visible steps to meet this obligation in recent weeks.

30, 2007

North [send him mail]
is the author of Mises
on Money
. Visit
He is also the author of a free 19-volume series, An
Economic Commentary on the Bible

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