"There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved."
- Ludwig von Mises

Tuesday, November 2, 2010

All Eyes on the Federal Reserve and the Upcoming Federal Budget

I think it's important to keep in mind one metric, and that is the US budget deficit.  From the Congressional Budget  Office website:

CBO estimates that the federal budget deficit was slightly less than $1.3 trillion in fiscal year 2010 and $125 billion less than the shortfall recorded in 2009. The 2010 deficit was equal to 8.9 percent of gross domestic product (GDP), CBO estimates, down from 10.0 percent in 2009 (based on the most current estimate of GDP). The 2010 deficit was the second-highest shortfall—and 2009 the highest—since 1945, relative to the size of the economy. CBO’s deficit estimate is based on data from the Daily Treasury Statements and CBO’s projections; the Treasury Department will report the actual deficit for fiscal year 2010 later this month.
So let's put this in perspective.  In 2009, the US "overspent" 10% of  GDP, and in 2009, the figure will likely be 9% of GDP.  These are two historic years for Congressional spending.  Yet GDP, according to many economists, is expected to remain at a roughly 2% level per annum for the next few years.  Here's the big question:  Is the US economy ready for a balanced budget?  Is the world economy ready for a US balanced budget?

That is, if in the last two years we have overspent (above tax revenues) 10% and 9%, yet have only maintained a 2% GDP growth, what happens if the US government does not have a trillion plus dollar deficit?  The 1.3 Trillion "created out of thin air" dollars that the US government spent this year had a tremendous impact.  Yet its impact was also softened by counterforce: a serious deflationary private sector debt deleveraging.  Thus, the tremendous impact the extra spending had was in maintaining the economy from severely contracting.  Whether you like Keynesianism or not, you have to admit that government spending, in the short run, stimulates an economy.

The US government has functioned as "training wheels" to the US economy these last two years.   What I mean by that is, the economy was about to fall over, and the US Government stepped in to support it. Now that it looks like the Republicans are ready to take over the Congress, or at least the House of Representatives, are we ready to remove those "training wheels?"  The Republicans are adamant about balancing the budget.  Is the US economy ready for that?  Here's a good diagram from contraryinvestor.com, it adds all US debts and obligations:

Since the early 1980s, US debt, whether it is debt from a municipality, the Federal Government, or any state, on average has been increasingly rising faster than GDP.  So what happens to GDP if the long term trend is a reversal of debt growth?  The only conclusion that I can come up with is that GDP contracts.

So what are we left with if Keynesianism can't come to the rescue?  From Bloomberg:

Fed Will Probably Start $500 Billion of Bond Buys, Survey Shows

The Federal Reserve will probably introduce an unprecedented second round of unconventional monetary easing tomorrow by announcing a plan to buy at least $500 billion of long-term securities, according to economists surveyed by Bloomberg News.

Policy makers meeting today and tomorrow will restart a program of securities purchases to spur growth, reduce unemployment and increase inflation, said 53 of 56 economists surveyed last week. Twenty-nine estimated the Fed will pledge to buy $500 billion or more, while another seven predicted $50 billion to $100 billion in monthly purchases without a specified total. The remainder said the Fed would buy up to $500 billion or didn’t quantify their forecast.

The varied responses reflect differences among Fed officials over the total amount of purchases needed to bolster the recovery. Policy makers, pursuing unprecedented stimulus, have cut the benchmark rate almost to zero and bought $1.7 trillion in securities without generating growth fast enough to bring down unemployment from near a 26-year high.

“There’s no silver bullet right now” and central bankers have “very few options left in terms of lowering interest rates,” said John Silvia, chief economist at Wells Fargo Securities LLC in Charlotte, North Carolina. He predicted $500 billion of Treasury and mortgage-backed securities purchases in the next six months.

Shock-and-Awe Plan

Disagreements among policy makers over whether to expand the balance sheet incrementally or stage a so-called shock-and- awe program of big asset purchases have created confusion among investors over the likely size and duration of any new easing, said Ward McCarthy, chief financial economist at Jefferies & Co. in New York.

“There has not been a uniformity of opinion emanating from the multitude of public appearances from Fed officials,” McCarthy said. He predicts the Fed will buy $500 billion of securities over the next six months and was among 13 economists who said the purchases would include mortgage-backed bonds in addition to Treasuries.

New York Fed President William Dudley set expectations at $500 billion in purchases when he said in an Oct. 1 speech that purchases totaling about that amount would add as much stimulus as lowering the Fed’s benchmark rate by 0.5 percentage point to 0.75 percentage point.

Dudley put the $500 billion figure “in there and it sounded like he was trying to move it along in that direction,” said Chris Rupkey, chief financial economist at Bank of Tokyo- Mitsubishi UFJ Ltd. in New York, who predicts the Fed will announce up to $500 billion of purchases by March.

Many Variables

Referring to investor expectations of the central bank’s next move, Rupkey said, “It’s a mess, and it’s just because there’s too many variables between the amount and the time period.”

St. Louis Fed President James Bullard said on Oct. 21 the Fed should buy $100 billion in long-term Treasuries this month and calibrate subsequent purchases based on the course of the economy. Atlanta Fed President Dennis Lockhart said that a pace of $100 billion of purchases a month is “in the range of numbers one might consider.”

Estimates by economists about the duration of a Fed asset purchase program ranged from as short as three months to as long as the end of 2011. Three analysts said the Federal Open Market Committee wouldn’t announce new stimulus.

Favorable Reaction

“It’s highly unlikely that anyone’s going to get all the details right because going into the meeting Fed officials themselves won’t have agreed on all of” them, Jefferies’ McCarthy said. He said he expects the Fed to buy mortgage-backed securities because it would be a positive surprise, and the central bank wants a “favorable market reaction.”

The lack of clarity over the Fed’s plans has played out in the Treasury market, which handed investors a loss of 0.18 percent in October, the first negative monthly return since March, according to index data compiled by Bank of America Merrill Lynch. After falling to 2.38 percent on Oct. 7 from 2.51 percent on Sept. 30, the yield on 10-year Treasuries has since climbed to 2.63 percent as of late yesterday, Bloomberg data show.

Not all Fed officials agree the central bank should start new stimulus measures. Kansas City’s Thomas Hoenig, who has already dissented six straight times, said on Oct. 25 that he opposes more easing because it’s “a very dangerous gamble” that may accelerate inflation and create asset-price bubbles. Dallas Fed President Richard Fisher and the Philadelphia Fed’s Charles Plosser have also spoken out since the FOMC’s last meeting against more action by the central bank.

Asset Bubbles

“When money is too easy for too long, we will have more” asset bubbles, former Fed Chairman Paul Volcker, an adviser to President Barack Obama, said today in Singapore.

Chicago Fed President Charles Evans said several times last month that the central bank needs to take action and should buy securities on a large scale to carry out his preferred strategy of aiming to raise inflation temporarily.

“They’re in uncharted waters here, and no one really knows, we’re all guessing” about the size and duration of the easing program and its ultimate impact, said Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut. “I haven’t seen anybody out there who has made a convincing case that this is anything but a trivial boost for the economy.”


The central bank last month asked bond dealers and investors for projections of its asset purchases over the next six months, along with the likely effect on yields. The New York Fed, the branch of the Fed System that implements monetary policy, asked about expectations for the size of the program and the time over which it would be completed, according to a survey obtained by Bloomberg News.

Stanley predicted the Fed will opt for the incremental tactic and announce a program to buy $200 billion of Treasuries by its Jan. 26 meeting.

“They want to preserve flexibility and to have the option of tweaking the pace as they go based on whatever it is that they choose to look at,” Stanley said.

“Clearly the thrust of this is to get long-term rates lower, but when you listen to what they say about it, they don’t even plan to get a lot of juice out of what they want to do,” he said. “What does that do for the economy?”

Dudley, who is also vice chairman of the FOMC, said in the Oct. 1 speech that the central bank would probably need to act to address “unacceptable” job growth and inflation.

Inflation Eases

The U.S. economy expanded at a 2 percent annual rate in the third quarter and inflation cooled, Commerce Department figures showed Oct. 29 in Washington. The report showed the inflation gauge watched by the Fed rose the least in almost two years as retailers like Wal-Mart Stores Inc. and Target Corp. use discounts to lure shoppers.

In addition to a new round of asset purchases, policy makers are also considering efforts to boost public expectations that inflation will rise, according to the minutes of the FOMC’s Sept. 21 meeting.

All but two economists predict the Fed will leave the interest rate on excess reserves unchanged at 0.25 percent. Fifteen analysts, including McCarthy, say the Fed will alter the phrase that its benchmark interest rate will stay near zero for an “extended period,” which was introduced in March 2009.

“They’ve been telling us they’ve been considering a change to the ‘extended period,’ so at some point they’re going to do it and this is as good a time as any,” McCarthy said.

Full article HERE.

Now, does anyone really believe anymore that securities purchases by the Fed contribute meaningfully in any way to the REAL economy?  My view is that the Fed is merely continuing to shore up the banks as the private sector continues to deleverage - voluntarily by paying down debt and involuntarily thru defaults.

We are continuing to delay the inevitable; the destruction of a monetary system.  And in the process, by delaying the inevitable, we are distorting the economy by continuing massive government sponsored malinvestments.  Thus, in a few years time, we will have to deal with an imploding currency, and a collapsing economy that has been increasingly based on debt driven asset valuations - a ponzi system that is nearing its end.

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