Here Comes the Spaghetti! The Fed's $850 Billion Bet.

The headline reads that the Federal Reserve is going to engage in a new round of quantitative easing. The Fed is going to purchase an additional $600 billion in U. S. Treasury securities over the next eight months, or $75 billion per month, in order to get the economy growing again.

The information that did not make the headlines is that over the same time period, roughly $250 billion will run off of the Fed’s Mortgage-backed securities portfolio. This $250 billion in Mortgage-backed securities will be replaced by the Fed with $250 billion in U. S. Treasury securities.

The world investment community sees a Washington, D. C. is disarray. The Fed is going crazy. (But, this is not the first time that Bernanke has shown panic. See “The Bailout Plan: Did Bernanke Panic”, http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.) And, the additional federal deficit is projected to be at least $15 trillion over the next ten years.

What we are seeing, in my mind, is the culmination of a half century or more of governmental economic policy that has had the wrong focus. This began with the Employment Act of 1946. Full employment became a goal of the United States government and the Federal Reserve was charged with the task of contributing to the achievement of this goal.

Right now, the Fed believes that there will be little or no stimulus programs coming from the federal government, especially with the changes in the makeup of Congress resulting from this week’s election. Thus, the Fed seems to believe that it must carry the full burden of reducing unemployment.

We have reached this state of desperation over a long period of time. The background of this environment is presented in the book by Raghuram Rajan called “Fault Lines” which just won the Financial Times award for the best business book of the year. (See my review of this book: http://seekingalpha.com/article/224630-book-review-fault-lines-how-hidden-fractures-still-threaten-the-world-economy-by-raghuram-g-rajan.) The next five paragraphs contain material from this review.

Rajan states that “Almost every financial crisis has political roots.” Beginning from this premise, he discusses the foundation of the economic policies of the United States. The root of the government’s economic policies, he contends, is the concern over “the growing inequality of income” in the United States, a disparity that can lead to political unrest.

Politicians, however, have not responded to this problem by focusing on the longer run solutions to inequality connected with education and opportunity, but has instead focused on short run solutions because of the nature of the American political process.

Rajan argues that these politicians have responded to the discontent this divergence in incomes creates in the electorate with two short run panaceas: first, the effort to achieve high levels of employment through the monetary and fiscal policies of the government. This resulted in the Employment Act of 1946 and the Humphrey-Hawkins Full Employment Act of 1978. The second is the effort to help as many individuals as possible own their own homes.

Thus the government has created policies that underwrite efforts to attain high levels of economic growth and employment and will provide downside protection against economic contractions and unemployment. Likewise, it will underwrite the supportive credit inflation of the private sector and will “save” financial institutions experiencing trouble on the downside.

Home ownership has become the default policy of government in the inequality debate because efforts to directly combat income inequality in the United States, Rajan contends, have been exiled from political debate. Supporting home ownership for as many people as possible and in as many ways as possible has been substituted. As a consequence, the number of programs, institutions, and incentives advocated for home ownership has grown to the point where they dominate most economic and social policies of the United States government. Credit creation is the vehicle of choice for the achievement of homeownership and prancing from “bubble to bubble” has become the essence of the fiscal and monetary policy that supports this effort.

The problem is that these policies don’t work over the longer run. In fact, the efforts to achieve success in these areas over time may do more to help the wealthy and educated at the expense of the less-wealthy and the less-educated.

In the fifty years that the efforts Rajan describes have been incorporated into the economic policy of the federal government, the United States has actually seen the inequality of incomes become even more skewed toward the higher end of the income spectrum.

And, it appears that most of the efforts of the Obama administration to protect and better the position of the less-wealthy and the less-educated have done exactly the opposite of what the administration intended!

For example, look at this article by Shahien Nasiripour in Huffington Post this morning, “Federal Reserve Rains Money on Corporate America—but Main Street Left High and Dry”. (http://www.huffingtonpost.com/2010/11/03/federal-reserve-qe2_n_778392.html)

So, who has benefitted from the policy of the Federal Reserve? The big banks. Big corporations. Emerging nations. (More and more of these countries are thinking of imposing controls on money flows to stem the flood of dollars coming across their borders), China. India. Brazil.

You don’t see on this list smaller banks, smaller businesses, middle class Americans, and so on.

And, who is capable of positioning themselves to take advantage of these federal monetary and fiscal policies? The wealthy and the educated…not the less wealthy or the less-educated.

Just a case in point: as the credit inflation of the 1960s and 1970s built up, the wealthy began to build portfolios of assets that served as inflation hedges. Houses, of course, were one of these assets.

In fact, housing became the piggy bank of many, many Americans during this time. But, since the prices of housing never went down during this period of credit inflation it appeared that one way to help the less-well-to-do in the society was to help them get a “piece of the bank.” The subprime loan was one of the last vehicles to get people into the piggy bank. I mean, how could they miss with housing prices rising 10% to 12% year-after-year. And, the Fed would never let these people down for long.

And, what about unemployment? Unemployment may actually be made worse by too much credit inflation. Trying to put people back into the jobs they have recently lost through credit inflation may only make the employment situation worse as under-employment grows, as it has over the past fifty years, and as capacity utilization declines, as it has over the past fifty years.

I really can see little or no good coming from this “quantitative easing”. However, I can imagine a lot of bad things happening. The plunge that is now taking place in the value of the dollar leads me to believe that a lot of other people believe the same thing.

"Currency Chaos: Where Do We Go From Here?"

I would strongly recommend you read the “Weekend Interview” published in the Wall Street Journal on Saturday. The interview is with Robert Mundell, 1999 Nobel prize-winning economist who teaches at Columbia University. Mundell has been referred to as the “father of the euro.” (http://online.wsj.com/article/SB10001424052748704361504575552481963474898.html?mod=WSJ_Opinion_LEADTop)

Let me just summarize some of the points Mundell makes in the interview because, I believe, that more people should be aware of them.

First, Mundell reflects a bit on history and states that the major event of the post-World War II period was the United States going off the gold standard in 1971 and letting the value of the dollar float. “The price of gold was fixed at $35 an ounce in 1934, but by the time the U. S. got through the Korean War, the Vietnam war, with all the associated secular inflation, the price level had gone up nearly three times.” The U. S. lost more than half its gold stock and had to get off the gold standard.

No one has suggested any system, gold or whatever, to stabilize prices since. And, the “secular inflation” has continued into the 21st century.

Second, the dominance of the United States and the dollar in the world economy, which began in the 1930s, has declined. “”To be fair, America’s position (in the international community) is not nearly as strong now.” But, Mundell doesn’t “think the U. S. has any ideas, they don’t have strong leadership on the international side. There hasn’t been anyone in the administration for a long time who really knows much about the international monetary system.”

Third, it is wrong to think that the world situation revolves around the United States versus China faceoff. “It’s a multilateral issue because the U. S. deficit is a multilateral issue that is connected with the international role of the dollar.” Mundell supports the suggestion of French President Nicolas Sarkozy that discussions should begin on reforming the world monetary system. But, he argues that the Europeans must play a very important part in any discussions because the dollar-euro relationship is so important in world financial markets. “The dollar and the euro together represent about 40% of the world economy.”

Fourth, the world currency system needs to be based on fixed exchange rates and not flexible ones. Mundell believes that almost all of the volatility in foreign exchange markets is “noise, unnecessary uncertainty.” World trade will be better off without having to deal with this “noise” because “it just confuses the ability to evaluate market prices.”

The argument against fixed exchange rates is that, in a world where capital flows freely between nations, a country cannot run an independent economic policy aimed at achieving things like full employment and price stability and still maintain a stable exchange rate. This argument is called “the Trilemma problem” of international economics: you can only achieve two of these goals; capital mobility; fixed exchange rates; and an independent governmental economic policy. (For more on this see my post, http://seekingalpha.com/article/227990-monetary-warfare-can-nations-have-independent-economic-policies.)

What about a country losing the ability to run an independent economic policy?

Mundell is asked the following question: “I suppose the Fed officials would argue that their mandate is to try to achieve stable prices and maximum levels of employments.”

The answer: “Well, it’s stupid. It’s just stupid.”

“The Fed is making a big mistake by ignoring movements in the price of the dollar, movements in the price of gold, in favor of inflation-targeting, which is a bad idea. The Fed has always had the wrong view about the dollar exchange rate; they think the exchange rate doesn’t matter. They don’t say that publically, but that is their view.”

Hence, the fifth point is that monetary and fiscal policy should not be conducted independently of what is going on in the rest of the world. A country, even the United States, cannot continue to inflate its currency without repercussions. The government cannot continuously ignore what is happening to the value of its currency. If a country does ignore what is happening to its exchange rate there will be consequences to pay down the road.

Sixth, “the price of gold is an index of inflationary expectations.” What is it reflecting? Mundell argues that a rise in the price of gold might indicate “that people see huge amounts of debt being accumulated and they expect more money to be pumped out.”

“Look what happened a couple weeks ago: The Fed started to say, we’ve got to print more money, inflate the economy a little bit. The dollar plummeted! (The price of gold rose!) You won’t get a change in the inflation index for months.” But, the decline in the exchange rate and the rise in the price of gold is a “first signal.”

Read the article.

Federal Reserve Non-Exit Watch: Part 2

During the Federal Reserve’s Exit Watch, the excess reserves in the banking system rose by $400 billion or so. Thus, as the Federal Reserve attempted to exit it put more reserves into the banking system.

Remember that in August 2008, the assets on the Federal Reserve balance sheet was no more than $900 billion…total!

Now we are told that the Federal Reserve, still concerned that the economy is not growing fast enough, has entered into a phase of not exiting the banking system, even expanding its stance of monetary ease by the tool affectionately referred to as “Quantitative Easing.”

Well, excess reserves in the banking system fell below the $1.0 trillion level in September for the first time since late October 2009. The decline in excess reserves in the banking system has reached almost $200 billion since the peak in this total was achieved.

Does anyone understand what the Federal Reserve is trying to do? Does the Federal Reserve understand what the Federal Reserve is trying to do?

I have argued many times in recent months that I have never seen such a lack of leadership at the Federal Reserve in my lifetime.

People claim that there is so much uncertainty in the economic and financial world right now that businesses and individuals don’t know what to do!

Well, you can look at the leadership of the Federal Reserve and get a prime example of why there is so much uncertainty around in the world.

The Fed looks positively leaderless!

In looking at the numbers from the Federal Reserve release H.4.1, “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks,” one could argue that over the past four weeks and over the past thirteen weeks the Fed has been facing some “operational” factors that have affected reserve balances and this has clouded the picture.

“Operational” factors are things like seasonal movements in currency outstanding due to cash needs during the summer months or during the Thanksgiving to New Year’s time period or in the management and payment of tax receipts on the part of the United States Treasury.

These factors usually appear of the side of the Fed’s balance sheet that “absorbs” bank reserves. For example, if the Treasury draws funds from commercial banks into its General Account in order to “write checks” this removes (absorbs) reserves from the banking system.

In the last four months, Total Factors Absorbing Reserves rose by almost $26 billion. This increase was centered in three areas. First, currency came out of circulation ($4 billion) as the summer came to an end. Second, the United States Treasury brought about $12 billion into its General Account at the Federal Reserve. And, the Federal Reserve engaged in more Reverse Repurchase Agreements with “Foreign Official and International Accounts” which rose by $9 billion.

The Federal Reserve did not offset these absorbing factors. In fact, Total Factors Supplying Reserves also fell, but only by a little more than $3 billion. This decline seems to have occurred as line items connected with the government’s financial bailout ran off.

So, “operational” factors seem to have accounted for the $29 billion decline in Reserve Balances with Federal Reserve Banks, (part of bank’s excess reserves) over the past four weeks. This is “not exiting”? At one time this amount of decline was about 3.5% of the Fed’s balance sheet!

At the same time the Federal Reserve replaced declines in its’ portfolio of Mortgage Backed Securities and Federal Agency securities by purchases of Treasury Securities. During the four week period ending September 30, 2010, the Mortgage Backed Securities portfolio declined by about $25 billion; the Federal Agency Securities portfolio dropped by about $2 billion.

The Fed upped its portfolio of Treasury Securities by a little more than $25 billion.

So the Fed appears to be replacing maturing mortgage-backed securities and federal agency securities with Treasury securities so that the overall portfolio does not decline by much. This is one thing the Fed said it “might” do.

One should note, however, that in the last 13-week period, the Fed’s portfolio of securities declined by almost $16 billion as the Fed did not replace all of the $40 billion in mortgage-backed securities that left the portfolio and the $11 billion decline in the portfolio of federal agency securities.

One should also note that during this last 13-week period $18 billion in accounts associated with the government’s financial bailout also ran off.

I don’t know what the Federal Reserve is doing. A lot of people don’t know what the Federal Reserve is doing.

All I can add to this is that the value of the United States dollar versus the Euro declined by about 8.3% since Chairman Bernanke spoke at the Fed conference at Jackson Hole, Wyoming in August and the Wall Street Journal index of the value of the United States dollar has fallen by over 6.6% since then.

A real vote of confidence.

Oh, No, the Fed is Expected to Discuss More Ways to Revive the Economy!

The New York Times contains the headlines, “Fed is Expected to Discuss More Ways to Revive Economy.” (See http://www.nytimes.com/2010/09/20/business/economy/20fed.html?ref=todayspaper.) The Fed is mulling over ideas about how it can provide more stimulus to the economy to get more “oomph” into the economic recovery.

Chairman Ben, at the Fed’s conference held in Jackson Hole, Wyoming in August, said that the Fed was prepared to “take additional action” to protect the economy from falling into a period of deflation.

My question is “why do we need more Fed stimulus”?

Let me talk about the long term. I know, Americans don’t like to talk about the long term. And, we have an election in six weeks and Americans are in the middle of a debate about tax cuts and spending plans and arguments about how we can get the economy going again. After all, Americans want something done within two years or less! (See my post “What Should the Fed do next,” http://seekingalpha.com/article/224423-what-should-the-fed-and-the-federal-government-do-next.)

Let’s talk about the longer term anyway.

Since, 1960 Real Gross Domestic Product has grown in the United States at a compound rate of growth of 3.14% through 2009. (It grew at a 3.34% compound rate through 2007, the peak of the most recent cycle.)

This compound rate of growth is consistent with what economists have felt that the economy could grow at over the longer term. In the 1960s, the expected long term rate of growth of the economy was put at 3.20%.

My question is, could the economy have grown any faster over this time period? If you would have told an economist in the 1960s that the economy would grow at a compound rate of growth of about 3.2% over the next fifty years, would he or she have taken that growth rate and “put it in the bank”?

Could it be, unless a government creates hyperinflation or serious deflation, that governmental economic policies have very little effect over long term economic growth although it can have significant impacts on underemployment, the utilization of physical capital, and income distribution?

Yet during this time period the politicians (and many economists) have continually put pressure on the government to push for greater economic growth, first cyclically, but then also in a secular way. And yet, decade after decade the compound growth rate of the economy has remained, roughly, in the 3.2% range.

The continued pressure to “goose up economic growth” through fiscal stimulus has resulted in a continued rise in the gross federal debt of the government. The compound rate of growth of the federal debt is just under 8.0% for the 1960-2009 period of time.

This pressure on the economy has resulted in a secular climb in prices over this same period of time of slightly more than 4.0%. As I have argued before, this was a perfect environment for financial innovation and massive debt-leveraging, exactly what we saw.

This economic environment resulted in businesses, state and local governments, and families accumulating excessive amounts of debt.

This fiscal pressure to keep unemployment low kept many businesses in the same “legacy” physical plant and equipment being utilized so that the businesses could put workers back-to-work in their old jobs. As a consequence, the capacity utilization of industry continued to fall from peak-to-peak throughout the last fifty years. Maybe, just maybe, some of this physical capital should have been allowed to leave the scene.

And, in terms of labor, since the government tried to keep unemployment low by forcing the economy to hire people back into their old jobs, maybe, just maybe, a class of people became less employable in the general economy. Under-employment grew constantly over the past fifty years and now about one out of every four people of working age are either unemployed or underemployed.

Furthermore, recent research indicates there has been a serious skewing of the income distribution in the United States. Maybe, just maybe, continuous efforts to stimulate the economy through the government's fiscal policies to keep unemployment low among those that are less educated or are blue-collar workers and keep them in their "legacy" jobs puts these people at a significant disadvantage in the modern economy. If this happens then the income distribution in the economy can become more and more unbalances over time.

Maybe, just maybe, the American economy needs to re-adjust, to get itself up-to-speed in the modern world. It seems as if every week, someone else is measuring that the United States as less-and-less competitive relative to other up-and-coming nations. Could it be that the economic policies of the government created this environment?

Maybe, just maybe, American businesses and families and state and local governments need to
reduce their debt load.

Maybe, just maybe, American businesses need to modernize and up-grade their physical capital.

Maybe, just maybe, some in the American workforce need time to become employable again. (However, because of the above, some workers may never be employable again: http://www.nytimes.com/2010/09/20/business/economy/20older.html?hp.)

Forcing stimulus on the United States economy can stale the economy from restructuring and may keep people and businesses and governments from making the incremental changes they need to make in order to stay current. And, incremental adjustments are not so hurtful, so costly, and so time-consuming, as the discrete jumps in the economy that come about after things have been “forced” to stay as they were for such a long time.

Maybe, just maybe, the Fed needs to allow events to progress in a natural way. The Fed has provided the banking system with $1.0 trillion in excess reserves. The FDIC is working out “problem banks” in an orderly fashion. (Another six banks were closed last Friday helping to maintain an average of 3.4 bank closing per week this year.) It is expected that bank closings will continue at a very rapid pace well into 2011. Maybe, just maybe, this is all the economy needs at this time.

More action on the part of the Fed may only create even more problems in the future. Maybe, just maybe, the Fed needs to avoid any sign of panic at this time.

What Should the Fed (and the Federal Government) Do Next?

This morning there is a series of articles in the opinion section of the Wall Street Journal titled “What Should the Federal Reserve Do Next?”. It consists of several short pieces written by well known economists. I recommend that you read them.

I would especially recommend the opinion piece written by Allan Meltzer, a professor of economics at Carnegie Mellon University and the author of “A History of the Federal Reserve”. The following quote is, I believe, especially important for the monetary policy of the Federal Reserve…and for the fiscal policy of the federal government.

“In ‘A History of the Federal Reserve,’ I concluded that the principal mistakes the Fed has made have resulted from giving excessive attention to current events and forecasts of highly uncertain near-term developments. By focusing on the short-term, the Fed neglects the longer-term consequences of its actions. The transcripts of FOMC show that the members are paying little attention to medium- and longer-term consequences.” (http://professional.wsj.com/article/SB10001424052748704358904575477580959771188.html?mod=WSJ_Opinion_LEADTop&mg=reno-wsj.)

Unfortunately, we are in a short-term world. Everyone focuses on “current events and forecasts of highly uncertain near-term developments.” As a consequence, there is a tendency to over-react to situations and, in doing so, set the stage for further difficulties down-the-road.

The policy-cycle has gotten shorter and shorter. Richard Nixon believed that he lost the 1960 election to John Kennedy because the economy was not performing well. Thus, when Nixon became president he focused on making sure the economy would be expanding during the 1972 election. He froze wages and prices and took the United States off of gold in August 1971 because he believed it was necessary to contain the inflation begun in the Kennedy-Johnson years so that he, Nixon, could re-stimulate the economy so that he would be re-elected.

This four year cycle became the “thing” for Presidents. Slow down the economy immediately after getting elected so that the economy could be re-started in time to get re-elected.

In the 1992 election, “It’s the economy, stupid!” became the mantra of the Clinton campaign. And this approach appeared to be was in Clinton’s election.

But, then a funny thing happened: the cycle shortened. The mid-term elections became the thing. Whereas the Democrats controlled both houses of Congress when Clinton took office, the 1994 congressional elections turned the tide and resulted in the President facing a hostile legislature for the rest of his tenure. Focus was placed on mid-term elections as well as presidential elections.

Bush (43) experienced a similar turn-around in the 2006 election where the Democrats once-again established their control in Congress.

Now presidents must get re-elected, but also get “their” Congress re-elected.

Current economic policy making in the United States is on a very short string…not that it hasn’t been for a long time.

The problem this creates is that the economy is never allowed to fully adjust to the economic dislocations that appear over time. The efforts to re-stimulate the economy are over-whelmingly aimed at putting people back to work in the jobs and industries that existed before the previous recession. As a consequence, the economy never fully adjusts as it needs to.

Several things can happen. Human capital does not evolve as it should to meet the changes in technology taking place. The result is that unemployment rises, but even more important under employment rises. America now faces the problem that about one out of every four individuals of working age is either unemployed or underemployed. Income inequality is highest in sixty years.

The capacity utilization in the United States has dropped continuously since the 1960s and still rests substantially below the previous levels attained. It is expected that the near-term peak in this measure will be well below the previous peak. This, I contend, is a result of the government’s efforts to force resources back into “legacy” physical capital. (See my post http://seekingalpha.com/article/213163-jobs-and-skills-the-current-mismatch.)

Another area of major concern is the debt burden taken on by individuals, businesses, and governments. In the past fifty years, the federal government has created deficits and excessive monetary growth to combat unemployment and income inequality and sustain as much economic growth as it could. This has been the perfect environment for people to take on more and more debt…and that is exactly what they have done.

However, history shows over and over again that debt levels can eventually reach heights that are unsustainable. And, when this happens, the debt loads have to be worked off. The relevant question is, have we reached that stage where people must de-leverage and work with lower debt levels? If this is the case, working off current debt loads will not be easy.

It takes time for economies to re-adjust and re-structure. Debt loads have to be worked down. Labor must be re-trained. Legacy capital must be replaced with physical capital more attuned to the age. And, continued monetary and fiscal pressure only delays such adjustment and makes American commerce less competitive. (See “U. S. Falls in Ranks of World Economy,” http://professional.wsj.com/article/SB10001424052748704362404575480023901940654.html?mod=ITP_pageone_4&mg=reno-wsj.)

Furthermore, the existing panic in United States policy making, both monetary and fiscal, is creating a world exactly the opposite of what policy makers seem to be attempting to achieve. For example, the Fed’s low interest rate policy is subsidizing the largest financial institutions and creating a world where more and more of the banking assets in America will be controlled by the largest banks. Currently, the largest 25 domestic commercial banks control 67% of the assets of the banking system. Analysts believe that this will go to 75% or 80% in the next five years.

In addition, the ranks of the middle class are dwindling. The low interest rate policy of the Fed has encouraged big companies, big banks, and the wealthy to borrow but these borrowers are just sitting on the cash waiting to engage in an acquisition binge once the economy starts to pick up steam. The middle class? Well, the middle class, those that have paid their bills, who have stay married and worked hard throughout their lives and have saved: this middle class is facing the fact that they will earn next to nothing on their savings. (See “Falling Rates Aid Debtors, but Hurt Savers,” http://www.nytimes.com/2010/09/09/business/economy/09rates.html?_r=1&hp.)

United States policy makers, in an attempt to stay in office, have advocated monetary and fiscal policies aimed at putting people back to work and making it easy for these people to buy “things”, especially houses. They continue to follow such “populist” policies in order to get re-elected and maintain their power. Both parties are guilty. (See my “Wall Street Greed vs. Washington Greed,” http://seekingalpha.com/article/219804-wall-street-greed-vs-washington-greed.)
The speech given recently by President Obama offering $350 billion in new economic stimulus, even though some of this is aimed at “longer term” projects, appears to be an example of just another politician experiencing the panic that comes with an upcoming election.

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!