When Does the Fed Start to Help?

"At what point does it start to mean something? Putting in context: I realize there's something like 700 TRILLION in derivatives out there. And that gov't debt is already massive. They've applied a 9 TRILLION band aid so far."

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Hi CC,

The "band-aid" only gashes the wound that much deeper. More debt makes the depression worse.

In an environment of entrepreneurial risk taking, new currency will fall out of helicopters, because willing borrowers waive their hands to launder the counterfeit cash. In an environment where venture capital moves to hiding, more counterfeiting only weighs the helicopter down.

The reason Bernanke's Princeton writings are foolish, and I said so on the way up too, is because he fails to understand the difference outlined in the paragraph above. That difference is best illustrated by short term Treasury rates, the same term the Fed lends. There is a good reason that T rates become high or low, and it is not the Fed.

Two basic scenarios:

(A) T rates soar when wealthy entrepreneurs pour loads of venture capital into the economy. They do so because they find a high rate of return when they expose capital to risk. The line at the Treasury window gets pretty short, so the government has to offer high rates of return to fund operations. Taxes produce a lot of revenue during A, so that's manageable.

(B) T rates dive when venture capital is pulled from the economy and protected. Treasuries suddenly receive a lot of bids.

In scenario A, when there is appetite for growth, Fed rates may chase rising T rates upward. During A, the Fed can actually control the currency supply to a degree. They can apply "the gas" which is clueless Fed-speak for keeping wholesale rates to banks a little lower than (rising) T rates, or they can hold rates steady and let the economy drive T rates even higher over time. By doing so, commercial banks can introduce/print/counterfeit more currency into the economy. Because more venture capital is available at rate that is, by definition, lower than the rate capitalists opt to protect cash, more borrowing will generally occur. The Fed can also tame the rate of inflation by raising rates to slow the counterfeiting process.

In scenario B, no appetite for venture capital, Fed rates must chase T rates sharply lower. During B, lowering the Fed rate the typical amount does not cause expansion of the currency supply. If Fed rates are above short term T's, the currency supply is generally shrinking.

The FOMC understands this, which is why they hired a chairman who doesn't. If the Fed chairman was encouraged and permitted to act quickly and decisively, the Fed rate could get under the short term T rate and gas might flow at least for a little while. That didn't happen. Bernanke either did not understand that a fundamental change had occurred, or the FOMC tied his hands. Probably both. Bernanke kept Fed rates as high as 10,000% the short term T rate. At times T rates even went negative; the difference was infinite.

So where are we today?

At a very interesting point.

Just like Dr. Evil can't quite comprehend how the world has changed since he embarked on his life of crime, and asks too little in ransom, Bernanke can't quite get his mind around the fact that new World B is very different from old World A. So the Fed Chairman continues to set policy based on outdated assumptions.

World B cannot survive on the old supply/demand equilibrium, because budget deficits are soaring due to a lack of tax revenue. We need to dump more instruments on the market to pick up the slack. Business owners will recognize this as a margin trap. The more you have to raise through new sales volume, the lower your margins. Once margins disappear, selling more is worse than selling nothing. That is where we are today, every T sold is a loser, a new obligation without the potential for increasing tax revenue down the road.

The FOMC wants to buy T's under these conditions, because they know the environment is deflationary and that raises the value of interest payments over time. That is why I've said before, low interest rate Ts are more valuable than high interest rate Ts. You should be doing what the FOMC is doing.

This goes to another question I am often asked: how do we know when the storm is over? When is is safe to "buy and hold" again? The answer is when T rates lead the Fed rate higher in a sustained trend that lasts for many years. That is when counterfeiting will come into in vogue again, and prices will rise. Ironically, rising prices are bad for investors, but people who ask that question are generally capital gains traders who think they are investors.