Setting the Record Straight on the Fed and “Zero-Interest Rate Policy”

It’s entirely possible I don’t have the time to write this right now. Poor me. But this is important, so I must make the time.

So listen up people. Time for STRAIGHT TALK. It’s important to get the facts straight because it gives us a chance to understand something about economics and do some critical thinking.

What am I talking about? Well, a lot of folks of an anti-Fed persuasion, and even some Fed-lovers, say we have “artificially low interest rates.” Among the generally economically literate folks who are my friends and acquaintances, I constantly hear “artificially low interest rates this” and “artificially low interest rates that.”

Is the interest rate distorted? Yes. But is the Fed the reason interests rates have remained so low?

The answer is no.

“But!” you say, “Bernanke is printing so much money! That money is used to buy bonds, which pushes down interest rates!”

Okay, I am going to blow your mind here: The Federal Reserve is not printing money. They have not added made any net additions to their balance sheet since the end of QE2.

In fact, the Fed has deflated! That’s right… they have sold debt, and reduced their balance sheet.


It is true. I will now proceed to show my evidence:

First, let us look at a long-term chart of the monetary base.

FRED Graph

Here we see the monetary base has skyrocketed since 2008. The first giant spike is what we retroactively call “QE1,” the massive purchasing of mortgage-backed securities during the financial crisis.

You’ll note there was a temporary reversal of such debt-buying just before the second huge spike: QE2, which spent $600 billion on US government debt. Again, following this spike there has been a reduction in the size of the Fed’s holdings.

Now let’s “zoom in” to the end of QE2.

FRED Graph

So from Summer 2011, we have not seen the monetary base increasing. The Fed has been jerking around the amount, but since the end of QE2 the total assets of the Fed has tended downward.

What about QE3? Well… what about QE3? As far as I can see, it either has not even started yet, or it is being offset by the sale of other Fed assets. In any case, the grinding weight of the American economy already has the recessionary momentum, and $40 billion a month isn’t going to matter.

That is why America is certainly entering a recession in 2013, and so Canada will also.

If this is true, and if it is also true that the Federal Funds rate has stayed the same the entire time, then something else must be keeping interest rates as low as they are. The contraction of the Fed’s balance sheet should cause the interest rates to rise. So what could it be?

It’s not actually a big shocker: the economy is extremely delicate. Extremely delicate. That’s because everything seems to depend on the whims of politicians and bureaucrats who will either:

  1. Pump more crack into the financial system and eke out a bit more cancerous economic ‘growth’, OR
  2. Let a depression come and bring the economy to its knees. Or another crisis will come and the economy will be brought to its knees anyway.

So what Robert Higgs calls “regime uncertainty” is at critical levels, forcing low growth and keeping unemployment high. Additionally, the huge banks don’t trust each other because they are all fundamentally broke and the financial system is such a twisted nightmare. Virtually all the money added by Bernanke has printed been packed into the banks excess reserves.

Graph of Excess Reserves of Depository Institutions

Could it be the case that if Bernanke were not paying interest on the banks’ excess reserves, that interest rates would rise? Probably not. They are already losing money by parking their reserves at the Fed. But they prefer to lose just a tiny bit of money, rather than a lot of money in a highly uncertain economy.

The same way investors will give their money to Geithner — GEITHNER, of all people! — for a negative real return. They would rather know they will gain nothing, or lose a percent or two, rather than lose 20% with some fund manager.

The Great Depression also saw record low interest rates, so the present state of affairs should surprise no one.

Now just to clarify, I am not defending Fed policy, I am not defending Bernanke. I loathe central banking in principle. Deflation, i.e. reducing the money supply, is not necessarily a good thing. Yes, falling prices are good. Yes, inflation is bad. But if you are going to have a central bank, then policy should be to maintain a stable money supply, and let the market determine the value of the currency. Reducing the money supply through open market operations is just as much of an intervention in the market as increasing the money supply, it just affects different people in different ways. For example, the debtor prefers inflation, the saver prefers deflation.

That being said, the money supply has been RELATIVELY flat now for over a year. When we’re talking about Ben Bernanke, isn’t that pretty much the best we can hope for? Much better than him flying around in his helicopter throwing trillions of dollars at the world’s problems, like he did up until mid-2011.

Don’t get me wrong. The Fed is still creating distortions, for example by buying up nearly all the 30-year Treasury bonds with the Twist program, and affecting prices of different assets. But… relatively speaking, the Fed is not causing too much trouble at the moment. Silver linings, I guess. If they let us go into a recession and come out of it the natural way, that would seriously be pretty swell.

I also believe that the Fed will print when they think they “need” to, but for the moment they are relying on PR and promises.

Remember, according to the Austrian theory of the business cycle, you can only maintain the “boom” phase by ever-increasing expansion of the money supply. You cannot raise then money supply and then stabilize it. You can’t even increase it at the same rate the entire time. Monetary policy must become more aggressive as the boom matures, and becomes more and more unwieldy. Otherwise, the bust inevitably comes.

Moving on, when the Fed announces it will maintain its target Federal Funds rate, it does not mean that their actions are determining what the actual rate is at the moment. That is the case now. They trick people into thinking they have it under control, but they don’t. The actual rate is determined by the overnight lending of the banks.

But when rates do start to rise, the Fed won’t need to print anymore money. They already did. The two trillion dollars they’ve added to the system will come flooding out, and by the magic of fractional reserve banking the entire universe will explode in 10 minutes in a reserve currency hyperinflationary apocalypse. The Fed won’t let that happen — if they still exist, they will crash the economy with Great Depression II to save the big banks. Remember, the Fed is there to protect the big banks. It is not there for “full employment” or “protecting the financial system” per se. Hyperinflation would destroy the big banks so it must be avoided from a central bank standpoint. High inflation on the other hand…

Anyway, hopefully CMR has been able to clear up this complex issue for some people.


Undercapitalized Scotiabank’s new acquisition.

Scotiabank is picking up a 51% stake in Banco Colpatria. I think it is pretty awful how big banks have their businesses essentially underwritten by the central banks and governments of the world, and then they scoop up acquisitions like these. Oh well. Scotiabank still has horrendously bad TCE numbers (under 3.5%, only CIBC and National Bank of Canada are worse), and in a lot of ways they look as bad as Lehman Brothers.

Interestingly, Scotiabank’s CFO says the bank will have 7-7.5% Tier 1 Capital ratio by 2013, as reaching that target puts them in good financial health. But this is still way too low. Canada’s banks remain among the world’s least capitalized. Getting new over-valued acquisitions like Banco Colpatria is not the best idea in my estimation. They should be aggressively strengthening their balance sheets.


Bank of America: WikiLeaks next target?

While the US government does damage control on recently leaked State Department cables, rumors are flying that Wikileaks next target is Bank of America. Wikileaks’ founder, Julian Assange, recently told Forbes that their next target is “a major American bank.

In 2009, Assange told Computer World:

At the moment, for example, we are sitting on 5GB from Bank of America, one of the executive’s hard drives,” he said. “Now how do we present that? It’s a difficult problem. We could just dump it all into one giant Zip file, but we know for a fact that has limited impact. To have impact, it needs to be easy for people to dive in and search it and get something out of it.”

I am pleading with Assange to release this information ASAP, before the US assassinates him. Do it in a big cumbersome Zip file, if you must. The impact will not be limited, I promise!

Canadian university budgets: standing at the edge of the abyss.

The Globe & Mail reports that Canadian universities face a budget nightmare brought on by pension shortfalls. Article highlights:

… Most faculty and staff have defined benefit pensions, which promise a set retirement income based on service and salary. But those funds suddenly cratered when markets crashed in 2008, most losing 15 to 30 per cent of their value. …

Two years ago, Dalhousie University’s $726-million pension plan lost 16 per cent of its value, leaving a $129-million solvency deficit – the amount that needs to be added so that if the university suddenly folded, it could honour the plan. …

The University of Toronto’s pension fund was the hardest hit, losing 29 per cent in 2008. As a result, the school expects to owe an extra $50-million a year on top of $100-million it already contributes from a $1.5-billion operating budget. Since an arbitrator recently ruled against a proposed premium hike for faculty and librarians, cuts to services are the likely solution again. …

Saskatchewan is in the midst of a three-year moratorium on solvency payments, while Manitoba and Quebec universities already enjoy permanent exemptions. So does Alberta’s UAPP, which the employers and employees run jointly, making employees “part of the problem, part of the solution,” Mr. Gupta said. But because UAPP lost 20 per cent in 2008, its employees now fork over nearly 2.4 per cent more of their salaries than they did two years ago.

Canadian universities are public institutions. The bloated pensions in the public sector are the product of the bubble mentality. When times were good, fund managers did not anticipate anything but steadily rising returns. They did not anticipate 2008. Now all the lavish promises of myriad pension plans seem unrealistic, to say the least. To keep these generous promises, universities will have to cut services for students who are already paying too much for their schools.

The article mentions about $2.06 billion pension deficits among select plans. And this is merely a snapshot of nine different institutions. In a small country like Canada, $2 billion is serious money. The final price tag will ultimately be much higher. And university pensions are just a snippet of a more general problem — unrealistically generous pensions in the public sector will become a cancer on Ottawa’s budget.

As with most western democracies, Ottawa is bound to obligations that it will be unable to meet without default, either through repudiation or Bank of Canada money printing. Ottawa is on the hook for $208 billion in public pensions, which is $65 billion more than Ottawa’s crony accounting previously suggested. This says nothing of the CPP, which will not withstand future demographic burdens, and is made up of 33% per cent fixed income, mostly government bonds, which will be decimated by the mass inflation that is sure to come. Then there are the obligations of individual provinces to various unions which are likewise unsustainable.

When the private pensions of Chrysler and GM were bust, governments intervened. University staff do not have the votes that inefficient auto workers have. But over time, as more pension funds are threatened, Ottawa’s nationalization of different retirement accounts is a very real possibility. This would be done in the name of the general welfare, of course. A government guaranteed return, say at the rate of Canada’s long-term bond, would be more reliable than the ups and downs of capital markets.

This is already reality in some parts of the world. This radical idea even gets serious consideration in the US.

Why would a government want to do this anyway? Two reasons: 1) It can help defer the bankruptcy for the CPP and federal employee pensions; 2) it confers control over Canadian capitalism because common stock carries voting rights. Think about how the US government got the president of GM to step down.

These dangers are not immediate, but they must be considered as you prepare for the future. The main lesson — whether you are a government employee sucking blood from the economy, or a productive worker whose blood is getting sucked — you cannot count on government promises for retirement.


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