Bernanke and the Irrational Markets

The Fed is backstopping the whole party...

NOT MUCH seems to bother investors these days, writes Greg Canavan for the Daily Reckoning Australia.

Central bankers have it all under control. After waiting for months for another round of quantitative easing, Ben Bernanke reckons there's no pressing need to do anything. Or so he said on day one of his two-day testimony to the US Congress.

But rather than go home disappointed, markets rejoiced instead. They take comfort that Bernanke will do something if required.

According to Bloomberg,

'Federal Reserve Chairman Ben S. Bernanke outlined options to ease policy further in case the flagging economic recovery fails to lower unemployment.

'Easing tools include further purchases of Treasuries and mortgage-backed securities, and altering the Fed's language on the outlook for interest rates, Bernanke told the Senate Banking Committee in Washington yesterday. Another option is to use the so-called discount window for direct lending to banks.'

But wait! On the second day Bernanke spoke too. It seems he really can do everything. Bloomberg again...

'Federal Reserve Chairman Ben S. Bernanke sought to assure lawmakers the Fed can limit inflation while providing record stimulus and won't allow consumer prices to rise in return for faster economic growth.

'"It will be a similar pattern to what we've seen in previous episodes where the Fed cut rates, provided support for the recovery, and when the recovery reached a point of takeoff where it could support itself on its own, then the Fed pulled back, took away the punch bowl," Bernanke told the House Financial Services Committee today in Washington.'

This is the problem when you get politicians who have no idea about the subject matter asking questions. Bernanke can just rattle off any old answer without scrutiny.

So let's scrutinize it a bit.

Firstly, to peddle the line that what we're seeing is a 'similar pattern' to 'previous episodes' is preposterous. The punch bowl used to be an apt description of what the Fed did for markets. Now the punch bowl is embarrassingly small for what the Fed is trying to achieve. Since 2008, they've filled the equivalent of a bath tub, or a small swimming pool.

So what would the Fed have to do to take away the 'punch bowl', as Bernanke quaintly calls it?

Well, right now the punch bowl is overflowing to the tune of US$1.5 trillion. That's the amount of excess reserves in the US banking system. Before interest rates can even think about getting back to working in a normal fashion, these excess reserves must disappear.

How would that happen?

Well, the Fed could shrink its balance sheet by selling off a bunch of US Treasuries and mortgage assets. In effect, the banking system would absorb the supply of paper with the excess reserves. Upon depleting these reserves, the Fed could go back to normal 'open market operations' to set the fed funds rate, which is the official cash rate in the US.

Open market operations refer to the buying and selling of US Treasuries (with cash created by the Fed) to increase or decrease the money supply and interest rates.

But let's be realistic, those excess reserves are not going anywhere. The Fed is even reinvesting the proceeds of its maturing assets and buying more US debt with it.

The thought of taking away the kiddies' swimming pool anytime soon is laughable. Rather, whatever is in there will likely stagnate for years. And when the next leg of this crisis arrives, which it surely will, the Fed will be filling the pool up again.

These comments from Ben Bernanke show the absolute duplicity of central bankers. To say on the one hand that he can promote recovery with a range of tools (including language?) but also avoid any nasty inflationary side effects by simply taking away the fuel when the market reaches some mythical 'takeoff' phase is high quality poppycock.

The market loves it though. It is very complacent right now. Check out the VIX, also referred to as the 'fear index'. It's heading down towards the lowest levels in the past three years.

The No-Fear Index

 

Source: Stockcharts

Eurozone breakup? No worries.

US economy nearing recession? Buy stocks!

Fiscal cliff approaching? Speed up!

China's economy slowing down? Short the miners, buy the banks!

What about the LIBOR scandal? That's just bankers being bankers. Move along!

We can normally make sense — or at least rationalize — the movement of the market. But recent events take the cake. We're either on the cusp of a new invention in wealth creation, or something very nasty and unexpected is about to happen.

Or, we are very wrong about everything, which is of course a distinct possibility.

So we don't leave you pondering our own idiocy, just one last thought on Ben Bernanke's babble. At what point can the US economy support itself without central bank or government support? If we examine what that support currently is it will show you the US is years away from economic independence.

One thing that is important to understand is that the Fed itself does not create credit or debt. It creates reserves for the banking system, which then use these reserves as a base for their own lending and credit creation. The amount of reserves it creates dictates the price of credit. So the Fed influences the price of credit and its quantity, but cannot create it directly.

Only the private sector (through the banks) and the public sector (via federal, state and local government) expand the supply of credit in the economy. Currently, the US economy supports about $54 trillion in total credit. To avoid slipping into recession, the economy needs credit growth of around 1.5%-2% per annum, or US$800 billion to US$1 trillion.

Since 2008, you've seen contracting private sector credit growth. It's not surprising then that the US Federal government has run US$1 trillion plus deficits since that time. It's the government that has propped up the US economy. And it will continue to do so in the absence of a big return to credit growth by the private sector.

The Fed's main role is to monetize existing debt. That is, turn illiquid, bad debt into cash. Or buy Treasuries to help the government maintain a debt-based system that is completely unsustainable.

That is the real role of the Fed. There will be no return to normal, no recovery reaching a point of takeoff, and no punch bowl to take away. There will only be more of the same. More government spending, more Fed monetizing.

Get the safest gold – stored securely in professional, non-banking sector vaults – at the lowest possible price with BullionVault...