by Gary North
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%.
Understand, 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 down.
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.
WHEN BANKERS WORRY, BERNANKE WORRIES
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.
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, Fortune reported 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 WILL THE FED DO NEXT?
Forecasting 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 stocks.
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
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.
Meanwhile, 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.
So, 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 Washington.
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.
August 30, 2007
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