Update On The Fed's Options

My friend Chris thinks I should be writing about America’s financial mess more. Unfortunately, I just don’t see myself as the guy who can do that knowledgeably. That’s why I sometimes post on these matters—hoping to stimulate insightful comments that I can understand.

In response to yesterday’s post in which I quoted Karl Denninger at some length—KD believes the Fed will ultimately pivot to fighting inflation to prevent American going down the toilet of hyper inflation—Chris wrote to tell me that I’m over the target:

Ever since the 2008/2009 Financial Crisis, our fiscal authorities (Congress) have completely failed in taking their responsibilities seriously. You may recall that the 2008 Fiscal Year budget was George W's last one, before Obama took over. There was no budget presented for the 2009 budget, well, it was technically presented by Bush, but quickly tossed aside by Obama and Congress, by mutual agreement, due to the "emergency" of the Financial Crisis. Our Government began operating on the basis of the Continuing Resolution. No more Regular Order. Harry Reid, then Majority Leader of the Senate, was only too happy to do so, as was John Boehner, in the House. You may recall that when Boehner stepped down, and Paul Ryan (with feigned reluctance) took the Speakership, he promised a "return to regular order". Well, it never happened. The budgeting process became one of "what did this department spend last year? Add 5 or 10% to that number and pass a resolution funding them".

Now, sadly, it was the FED's policies of Quantitative Easing that facilitated the massive increase in deficit spending, allowed the politicians of both parties to escape responsibility for making the hard decisions, and gave cover by funding the spending under the guise of propping up our Banking system. And while I am a supporter of most of Trump's policies, I do think he wasn't being realistic about our fiscal situation when he praised the FED for keeping interest rates low. But then, he was a Real Estate developer and they live on using other peoples' money to fund their projects, so I'm not surprised. Don't get me wrong, I liked most of what he was doing, but I think he was a bit disingenuous when it came to the budget, and he could have made an issue of it, but didn't.

Despite the supposed independence of the FED, it is very much a political animal. It is dominated by PhDs in Economics, who in all likelihood lean left in their political views. The FED is, after all, a creature of the Progressive Movement, scientific management and all that other claptrap that pollutes the minds of the Elites. As such, it has proven itself to be too willing to take actions that facilitate the major weakness of Democracy. That being "it is a wonderful thing, until the voters realize they can vote themselves the largess of Government". The FED has made that possible.

Their hand will be forced, and the pain will be felt by all, to varying degrees. Their foot dragging could, quite possibly, be motivated by a desire to give those at the top end of the scale the time they need to get out of the way. I would encourage you to go back and research the background on the Great Financial Crisis to see who the players were. During all the meetings taking place with Hank Paulson (Bush's Treasury Secretary) and other political leaders in the early days of the crisis, the only non-Treasury folks in the room were from Goldman, Sachs. Ever wonder why AIG got bailed out by the FED? Because Goldman Sachs had huge, counterparty positions to AIG's credit default swaps. If AIG had failed (very likely, due to their risky, aggressive portfolio), it would have taken Goldman down too. Paulson was a former Goldman partner. In order for Goldman to qualify for the FED's assistance, they had to get a Banking Charter, which were being awarded like candy back then. Other Wall Street Investment Banks were given the same opportunity to qualify for FED assistance and most took advantage. Heck, even GM's auto finance arm GMAC got a charter, got bailed out, and became Ally Bank.

Chris also sent a link—it’s full of charts that I can’t grok:

The Fed Is Trapped: It Has No Room to Taper or Raise Rates

Some readers may be able to absorb the information and comment. The author ends on a pessimistic note, which I take to be the major point of the article. The web of the Fed’s own making is, as I also take it, a direct result of what Chris described above (plus earlier bailouts of Wall St.):

In addition, commercial banks are registering unrealized losses again. An increase (decrease) in the value of the assets that a bank has on its balance sheet represents an unrealized gain (loss) which would occur if the assets were sold. One of the measures the Fed often takes to convert unrealized losses into unrealized gains is to lower the federal funds rate.

Note (in chart 8) that when the Fed raised the federal funds rate (green line, right axis), the banks started to register unrealized losses (purple line, left axis, below zero). To prevent this, the Fed started to lower the federal funds rate. Also note that recessions (represented by the grey bars) have occurred most times after unrealized losses have been registered. That does not mean that there will be a recession right now, as there are other factors to consider. But it shows how fragile the system is, considering that the Fed is barely tapering (let alone raising rates or shrinking its balance sheet) and the banks are already facing unrealized losses.

Chart 8: Banks' Unrealized Gains/Losses and Federal Funds Rate, 1998–2022

Source: FRED; author’s own elaboration. Note: Banks' unrealized gains/loss are the purple line read against the left axis, and the federal funds rate is the green line read against the right axis.

Conclusion

The Fed is trapped in its own web. It does not have much room to raise rates without major complications in the financial market and in the economy. Even if it finally delivers on tapering and starts raising rates, it won’t get any further than it did back in the last rate hike (2015–18) and balance sheet shrinking (2017–19) cycles.