Safehaven | Will the Fed Cut Rates again on December 11?

November 26, 2007

Will the Fed Cut Rates again on December 11?
by Randy

If Federal Open Market Committee (FOMC) members were to center their December 07 rate decision around the basis of Treasury Secretary Paulson's continually spouted "Strong Dollar Policy" there is absolutely no way they could make a rate cut, as the dollar is falling off a cliff and its rate of decent is increasing.

Bloomberg 24 Nov: The U.S. Dollar Index touched 74.484 yesterday, the lowest since the gauge started trading in 1973. The index tracks the value of the dollar against six major currencies, including euro, yen, pound, Canadian dollar, Swedish krona and Swiss franc.

So what is happening in the financial realm and why is the dollar falling so fast? Well, a big part of the answer to this question relates directly to debt and the creation of money.

For those of you who don't know, every dollar in circulation today was actually borrowed into existence and was created from nothing. For many years this creation of new money through debt was not a problem. As long as the debt could be adequately serviced and various conduits (banks) were open to/available to take on new debt, the system worked just fine.

Recently however, it has become abundently clear to our Federal Reserve Policy makers that massive US debt loads are proving very difficult to service, while at the same time our banking systems are having problems allowing for the creation of new debt (hence new money). This is all VERY BAD news that could cause a systemic implosion if not dealt with swiftly. Therefore, the Fed is monitoring this crisis closely and is lowering short term borrowing rates while injecting massive amounts of new money (through new bank debt) into the banking systems. This combination of excessive liquidity (monetary injections) and lower rates is causing the value of the dollar to plummet. See video below for a better understanding of this whole debt-to-money process (money as debt)

MONEY AS DEBT (~11 seconds to load)

Video Summary: money is created through debt and in order to keep an economy expanding, debt loads must continually expand (increasing money supply) or else a deflationary environment sets in.

As previously stated: today, after many years of cheap/easy credit (much of it subsidized by foreigners -- we used to suck up 80% of the world's surplus savings) US debt loads are now at an all time high and adequately servicing this debt has become a huge problem.

A perfect example of this problem is the US housing market. Back in the heyday of our irrationally exuberant housing market, nearly anyone could qualify for a mortgage. We had >100% financing, super low teaser rate mortgages and even NINJA Loans (No Income, No Job, No Assets). All this easy money led to no-risk investment speculation and caused a huge new wave of home buyers (many who couldn't previously qualify). This led to supply/demand imbalances, which drove home prices up dramatically.

Today however, things are a bit different. As these initial teaser rates on millions of mortgages began to reset, servicing this additional debt became unbearable for many and defaulting was the only option. These defaults (in the $ tens of billions per month) eventually led to the collapse of several hedge funds, a significant tightening of lending standards and ultimately to a complete immobilization in the Securitized Mortgage Backed Commercial Paper market -- where recent financial losses & bank write downs have been massive (yet merely the tip of the iceberg to date).

But, these write downs are only making matters worse, as each dollar of the losses eats into available bank capital, creating an additional burden to future lending, which tightens lending standards further, prevents the creation of new debt, and causes further downward price pressures on all those homes that sit unsold.

Additionally, part of the domino effect caused by reduced home sales (due to less available credit) is lowered sales volume at home improvement, furnishing and a myriad of other stores -- cutting into business profits, leading to less work hours, increased layoffs, et cetera.

Ultimately, reduced credit leads to reduced money creation, which leads to reduced spending which leads to a deflationary environment.

That is where we are today... The beginning of a deflationary environment poised to implode the economy...

Well have no fear Ben Bernanke and the boyz are here!

In a 2002 speech before the National Economists Club in Washington, D.C., Ben Bernanke made it clear the Fed should do everything in its powers to prevent deflation: Deflation: Making Sure "It" Doesn't Happen Here

So, what are the tools Ben feels the Fed should use to prevent deflation?

Well, based on his comments, the Fed could cut rates to ZERO, while simultaneously they could print/inject massive amounts of fiat money into the system. See excerpts of the link below (Note: Emphasis is mine)

" But suppose that, despite all precautions, deflation were to take hold in the U.S. economy and, moreover, that the Fed's policy instrument -- the federal funds rate -- were to fall to zero. What then? In the remainder of my talk I will discuss some possible options for stopping a deflation once it has gotten under way".

Could this comment be a sign of things to come -- Zero percent?

"Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."

There you go, he said it -- print more money to reduce its value and to generate more spending (sounds like a call for Hyperinflation)

"Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior).8 Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system -- for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation."

I believe what he's saying is: the Fed will reduce rates simultaneously while increasing liquidity, but the fireworks (printing/monetary injections) will really have to pick up steam once we're at zero because the Fed's ammunition canister will then be empty.

"The Fed should and does use its regulatory and supervisory powers to ensure that the financial system will remain resilient if financial conditions change rapidly. And at times of extreme threat to financial stability, the Federal Reserve stands ready to use the discount window and other tools to protect the financial system, as it did during the 1987 stock market crash and the September 11, 2001, terrorist attacks."

Huge discount window operations have become a regular thing of late, while the rules were recently changed to allow banks to pledge a broader range of commercial paper as collateral. Are we currently experiencing an extreme threat to our financial stability? Nah, can't be -- the media keeps telling me everything is fine.

"Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly.¹² However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window.¹³ Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral.¹⁴ For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector, over and above the beneficial effect already conferred by lower interest rates on government securities.¹⁵"

Minus the zero interest, I think we're already there.

Bottom Line: Back in 2002, Ben Bernanke highlighted what he would like to do if faced with the problem of deflation. Well, his test has just begun and deflation is now standing at our doorstep. Thus far, with consumer price inflation raging and the dollar tanking around the globe, Ben and the Boyz have been working overtime in an attempt to bail out our banking/financial sectors. They see the approaching financial train wreck, barreling downhill at ever increasing speed, and although they would really like to back Treasury Secretary Paulson's Smoke and Mirrors "Strong Dollar Policy", it is far too late for that. They are now stuck between a rock and a hard place (Deflation/financial collapse is the rock; Hyperinflation is the hard place) and they have chosen the hard place -- Hyperinflation

With bank losses mounting, Ben and the Boyz know that they are waay behind the power curve in their rescue attempts and that deflation is setting in. Therefore, I feel pretty confident in predicting that come December 11th, rates WILL once again be cut.

As an aside, If we are fortunate enough to evade a complete systemic banking failure, I think the tools used (printing presses and helicopters) will force us into a Hyperstagflationary environment (Hyperinflationary consumer price inflation combined with slow-to-no output growth, rising unemployment, and recession) This should allow us to muddle through until ~ 2010, but unfortuantely I don't think the "Big D" can be avoided forever. My bet is: 2011/2012.

Randy
contrarian2day

Disclaimer: These articles merely reflect the opinions of this author and are by no means a guarantee of future economic conditions. Though the author strives to provide accurate and relevant data, he sometimes relies on external sources and cannot assure the reader of the accuracy contained within. Additionally, these articles are provided for INFORMATIONAL PURPOSES ONLY and are NOT MEANT to provide investment advice to anyone. For investment advice, please consult with your professional financial planner.