Mr. Bernanke Gets His Way

Well, Mr. Bernanke has moved the Federal Reserve to a position of greater transparency. 

We now have projections of interest rates out until the end of 2014.  It is now believed by most members of the Fed’s Open Market that the Federal Funds rate will remain close to zero until the end of 2014.

What is the probability that the Federal Funds rate will be close to zero for the last six months of 2014?

In my mind, zero or close to it!

What is the probability that the Federal Funds rate will be close to zero for the first six months of 2014?

In my mind, zero or close to it!

What is the probability that the Federal Funds rate will be close to zero for the last six months of 2014?

You guessed it!

And, so on…

Seems like I don’t have a lot of confidence in these forecasts. 

What are these forecasts for, then?

I have already written my answer to this question.  These forecasts are to make Mr. Bernanke feel better. (http://seekingalpha.com/article/317453-bernanke-transparent-about-his-lack-of-self-confidence)

Mr. Bernanke doesn’t want to be misunderstood.  Apparently, in the past, Mr. Bernanke feels that he has been misunderstood.  Now, with the “new transparency” there should be no doubt where Mr. Bernanke and the Fed stand…and Mr. Bernanke should feel justified.

This is the first time in my mind that the Federal Reserve has done something of this magnitude so as to make the Chairman of the Board of Governors feel better.

I hope it achieves its goal because as far as I am concerned this new transparency program does absolutely nothing for me in terms of understanding where interest rates are going to be for the next two to three years.  It does absolutely nothing for me in terms of understanding what the monetary policy of the Federal Reserve is going to be for the next two to three years. 

If anything this new transparency program will assist, in the shorter-term, speculators in making lots of money.  George Soros, and others like him, loves a situation in which a government says it is going to maintain a price for as long as it can.  This type of government activity creates “sure thing” bets. 

The economy is in the condition it is in because there is still a lot of insolvency around.  By keeping short-term interest rates as low as they are helps financial institutions and other private or public organizations remain open hoping that they will be able to work themselves out of their insolvency. 

According to a report released Wednesday put together by the American Bankers Association and State Bankers Associations, thirty percent of the commercial banks reporting were under some form of written agreement with regulators.  A total of 1000 banks responded to the survey, so the study should be fairly representative.  Extrapolating this to the total number of banks in the banking system we would get some 1,900 banks under some kind of agreement with the regulators.   

This is when there are still some 864 commercial banks on the FDIC’s list of problem banks, which we know does not include all the banks under some kind of agreement with the FDIC. 

Many home owners still find the market values of their homes below the amount of the mortgage that exists on the property.  Commercial real estate loans are still defaulting at a very rapid pace and many businesses are declaring bankruptcy or are near filing for bankruptcy, especially small ones.

It is understood that the Federal Reserve must continue to protect against further economic deterioration and must continue to protect those individuals and institutions that are insolvent or near insolvency. 

Because of this and the consequent slow pace of economic growth the Fed must continue to keep the economy excessively liquid.

I don’t know that publishing interest rate forecasts for the next three years will convince us any more that the Fed is attempting to protect the banking system and the economy.  I guess it must help Mr. Bernanke to sleep better to know that he is releasing all this information even if it does little or nothing for anyone else.           

Bubble, Bubble...Where's the Bubble?

In Bloomberg Businessweek, Nouriel Roubini is quoted as saying “Zero interest rates are leading to an asset bubble globally…”

What is an “asset bubble” and how can one identify it?

Is an asset bubble like pornography? “I can’t define an asset bubble, but I know one when I see one!” Thank you Supreme Court Justice Potter Stewart.

Such a renowned economic prognosticator as former Fed Chairman Alan Greenspan couldn’t identify a bubble. He argued that you cannot identify an asset bubble before the fact. One has to wait until an asset bubble is over before you can identify it as an asset bubble. That sure builds confidence!

In Wikipedia, an asset bubble…or economic bubble…or whatever…is defined in the following way: An economic bubble (sometimes referred to as a speculative bubble, a market bubble, a price bubble, a financial bubble, a speculative mania or a balloon) is “trade in high volumes at prices that are considerably at variance with intrinsic values”. (Another way to describe it is: trade in products or assets with inflated values.)

Others have spoken of a credit bubble. A credit bubble is a situation where the rate at which credit is flowing into the economy, financial markets or sub-segments of the economy or financial markets exceeds the growth rate of other parts of the financial markets or the economy causing the prices of assets in the economy, financial markets or a sub-segment of the economy or financial markets to rise much faster than elsewhere.

The example that quickly comes to mind is that of the housing markets in the 2000s where credit was flowing into this sub-segment of the economy at a much faster rate than elsewhere causing housing prices to rise much faster than prices were rising in the rest of the economy. Although, before the fact, as Alan Greenspan stated, he could not identify this as a credit bubble.

But, Roubini has stated that current Federal Reserve policy (“zero interest rates”) is “leading” to an asset bubble. The bubble is not here yet, but it is on-the-way.

What might be behind this argument?

Well, since December 16, 2008, the lower bound of the Fed’s target Federal Funds rate has been zero. Since that date the daily average of the effective Federal Funds rate has been between 8 basis points and 22 basis points: effectively zero.

Getting into this position of “zero interest rates” and “quantitative easing” the Federal Reserve, through the financial crisis in the fall of 2008, moved to increase the Reserve Bank Credit it injected into the system from $892 billion on August 27, 2008 to $2,245 billion on December 11, 2008, just before the “zero” interest rate target was approved by the Fed’s Open Market Committee.

Commercial bank held balances with Federal Reserve banks of $12 billion on August 27; on December 11 the total was $773 billion. In the month of August 2008, excess reserves held by commercial banks was less than $2 billion; in the month of December 2008 this total rose to $767 billion, an increase of more than 38,000%!

In the first six months of 2010, reserve balances with Federal Reserve banks and excess reserves in the commercial banking system both hovered around $1.1 trillion!

Federal Reserve releases have implied that the target interest rate will stay at such low levels for “an extended period” because of the weak economy. In recent weeks, analysts have argued that such low levels will be maintained into 2011. Now, a new study by Glenn Rudebusch of the Federal Reserve Bank of San Francisco (see “The Fed’s Exit Strategy for Monetary Policy”, http://www.frbsf.org/publications/economics/letter/2010/el2010-18.html, and as reported in the New York Times, http://www.nytimes.com/2010/06/15/business/economy/15fed.html?ref=todayspaper) argues that target interest rates may stay low into 2012!

“If the rate were raised too soon, it would be hard to reverse course, whereas if tightening is started too late, the Fed could catch up by raising rates at a rapid pace.”

But, interest rates are not asset prices! Asset bubbles or credit bubbles occur when credit (funds) flow into the economy or the financial markets or sub-segments of the economy or financial markets at a pace that exceeds the speed at which things are growing.

In the 2000s, we had excessively low interest rates and things were felt to be OK because the economy did not seem to be growing excessively and consumer price inflation appeared to be under control. Yet, we got the boom in housing prices…and, in stock prices. (Note, that neither of these prices is included in the Consumer Price Index. Housing costs are included through an imputed rental value which has very little to do with the price of a house itself.)

Much of the liquidity the Fed has pumped into the economy is, so far, just setting on the balance sheets of financial institutions…and, non-financial institutions. The commercial banks are not the only ones “piling up cash reserves. See “U. S. Firms Build Up Record Cash Piles,” http://online.wsj.com/article/SB10001424052748704312104575298652567988246.html?KEYWORDS=justin+lahart.

“The Federal Reserve reported Thursday that nonfinancial companies had socked away $1.84 trillion in cash and other liquid assets as of the end of March, up 26% from a year earlier and the largest-ever increase in records going back to 1952. Cash made up about 7% of all company assets, including factories and financial investments, the highest level since 1963.”

At some time, these cash balances, at financial institutions and non-financial institutions, are going to be used. The totals are so huge, I can’t imagine that “the Fed could catch up by raising rates at a rapid pace,” as Rudebusch suggests in his paper. When these cash balances are used, the impact will be on asset prices and not on consumer prices. This represents the potential for the “asset bubble” Roubini is talking about. And, remember, bubbles “break”!

Just one other point on this: I believe that what is happening in European financial markets is a part of this “bubble” activity. International investors are not acting like they are scared and strapped for funds. Their aggressiveness, to me, indicates that they are flush with money and hence have the confidence to be aggressive in attacking the financial condition of euro-zone countries on the sell-side. Investors “in dire straits” do not take on sovereign nations. This indicates, to me, that there are plenty of “well off” investors in the world that can move money around and “make things happen.” The European situation is a result of the U. S. “quantitative easing”. Further “quantitative easing” just exacerbates the problem!