Money Creation Betrays Fed Insanity

Stocks respond positively to QE2 but for how long?

It’s the Ides of December, if December has ides. Some months do. Some don’t.? Yesterday, we drove up to Frederick, Md. It is the site of the encounter, fictional,? between Stonewall Jackson and an old woman. More on that, below.

Those of us who are condemned to follow such things found out that the Fed is standing pat this week. You can imagine how that stirred our blood. We had barely slept before Tuesday, wondering what the Fed would do. We had worn out the carpet, pacing back and forth. And now we discover that the Fed will do nothing!

The “recovery” is too weak to raise rates, said the Fed, and the economy may need more stimulus, it added; so it will stick with its plan to buy $600 billion worth of U..S government debt and maybe even a little more.

You’ll remember that the Fed purchases were supposed to drive down long-term interest rates so that mortgage borrowing and capital investment increased. But instead of falling, long-term rates went up.

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On the surface of it, you might think the Fed chief would lower his head…and admit that his quantitative easing plan is a colossal failure. Since March ’09, he has committed an amount equal to more than an entire year’s output of the U.S. economy to his QE initiatives. With so much of the nation’s treasure lost, you’d think he’d offer to slit his wrists or at least resign, but that would just go to show that you’ve never studied modern macroeconomics. If you spent a few more years in school, maybe you too could begin to see that up is really down and black is actually white. The Fed’s actions will quadruple the U.S monetary base. Is it any wonder investors are getting suspicious of U.S. dollar-denominated paper?

In theory, the Fed’s purchases of Treasury debt are absurd. In practice, they have backfired. So, the Fed will do more of them. Makes sense, right?

The U.S. bond market could be signaling that it is headed the way of Greece, Ireland, and Lehman Bros. Who wants an IOU from someone who can’t pay it back? Once the selling begins, it is hard to stop. Interest rates go up, increasing the cost of financing for the debtor. Pretty soon, he can no longer fund his on-going expenses or make the payments on his debt. He is forced into bankruptcy.

Meanwhile, the latest numbers from Robert Shiller tell us that the US stock market is 33% overvalued. Our guess is that stocks will go down much more than that number implies. Markets tend to overshoot in both directions.

The latest news from China tells us that the Middle Kingdom could blow up at any time. Nearly half the GDP is spent on capital improvements (usually things that involve concrete and steel). It’s breathtaking to see it, but there’s no way you can make that many capital investment decisions without making some colossal blunders.

From Europe comes a bleak and foreboding assessment: European banks have five times as much government debt as they did 3 years ago and even U.S. banks have nearly $350 billion worth of debt from Europe’s wave-washed periphery. Investors are selling off Spanish bonds; another chapter in the debt crisis could be at hand.? Dear reader, you are faced with a grave and dangerous situation. In front of you is the Valley of Death for investors.

America’s stock market could crash at any moment. Its bonds are slipping. Its homes are sinking. China could collapse into a heap. Europe could come unglued. Trade could fall off a cliff. Interest rates could rise everywhere. Another great depression could be coming soon.

CEOs are optimistic, says one report. Investors are overwhelmingly bullish, says another. And your captains are telling you to “charge ahead!”

Our advice: Take cover!

No Admitting Defeat: Fed to Fight Failure With More Stimulus by Bill Bonner originally appeared in the Daily Reckoning.

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Federal Reserve Subverts Fiscal Responsibility With Cash Creation Machines Fully Cranked

Quantitative easing removes urgency from austerity moves by Congress

So, this is what life after “QE2” looks like:

• Record gold prices
• Stocks back at pre-Lehman levels
• A dollar cruising toward its 2008 lows.

Everything is rallying in terms of depreciating dollars. Mission accomplished. Ben Bernanke needs George W. Bush’s ol’ “shock and awe” flak jacket.

In case mainstream media coverage made you glaze over, here’s the quick and dirty of the Federal Reserve’s fateful decision:

• The Fed will buy $600 billion in Treasuries over the next 8 months
• The mortgage securities the Fed bought during QE1 now reaching maturity will continue to be rolled over into Treasuries, as they have been since August. That’s another $275 billion, give or take
• There was also the caveat that more of this could be in the works if unemployment stays high and inflation (as defined by core CPI) stays low.

If the federal budget deficit is supposed to run $1.2 trillion during fiscal 2011 (that’s the consensus guess) and the Fed will purchase $875 billion in Treasuries over the next eight months (that’s two-thirds of a year)?then we quickly see the Fed plans to monetize all of all the debt that Treasury plans to spit out from now through the middle of next year and then some.

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This is yet another reason we don’t expect the House Republicans to convert to the gospel of fiscal responsibility any more than they did last time they were in the majority: They can indulge in demon spending unto oblivion and the Fed will have their back.

“If this were Greece or Ireland,” Bill Bonner wrote yesterday before the announcement, “the government would be forced to cut back. With quantitative easing ready, there is no need to face the music. If bond buyers will not finance America’s trip to bankruptcy, the Fed will provide as much brand-spanking-new money as necessary.”

The main difference between QE2 and its predecessor is this: The bulk of the junk the Fed put on its balance sheet during QE1 was mortgage securities, with about $300 billion of Treasuries thrown in for good measure. Now it’s all Treasuries, all the time.?Most of those Treasuries are of medium-term duration: very few 30-year bonds are in the mix. Thus, the yield on the long bond rocketed past 4% yesterday. It sits at 4.05% as we write.

Still, what’s really notable about QE2 is the form it did not take. In August, former Fed vice chair Alan Blinder wrote an Op-Ed in The Wall Street Journal. He tossed out a number of suggestions for QE2 that, for better or worse, would actually goose the economy and not just shore up the banks’ balance sheets:

• The Fed could buy assets beyond the realm of Treasuries and mortgage securities. It could buy corporate bonds, small business loans, or credit card receivables
• The Fed could stop paying interest on excess reserves to member banks. And if that didn’t encourage them to make more loans…
• The Fed could start charging the banks interest to stash their excess reserves.

Yesterday, the Fed chose “none of the above.”

It didn’t even take up Blinder on his suggestion to adopt new language hinting at an even-longer lasting commitment to near-zero rates. We just got the same old blather about “exceptionally low” rates “for an extended period.”

“Today,” Fed chief Ben Bernanke wrote in Thursday’s Washington Post by way of explaining himself, “most measures of underlying inflation are running somewhat below 2%, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run.”

Of course, that “underlying” inflation level does not take into account your need to eat, or heat your home or drive to work. It’s only going to get worse. Your neighborhood grocer is seeing his costs rising. “The big challenge,” says the CEO of a California grocery chain to The Wall Street Journal, “will be how much can we swallow and how much can we pass along?”

He’s holding out as long as he can, but skimping on tires for your delivery trucks (seriously, that’s one of his cost-cutting measures) only gets you so far.

Yesterday, we discussed rising food, gold and commodities costs in the context of the Fed decision during this interview with Financial Survival Radio. Have a listen here:

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