Investing for Sustainable Gains

I saw some comments over on CalculatedRisk which compel me to explain how the Federal Reserve actually works in reality. It is different from the Fed’s self-generated mythology – and also from the skeptics’ mythology.

The Fed will have you believe that they “set interest rates”.  The skeptics will say no, the market sets rates, and the Fed merely follows and claims victory.

Neither is true, and yet both are true.  As usual, look not at what they say, watch what they do, and follow the money!  What does the Federal Reserve actually do?  They buy and sell debt, and they talk a lot.  But it is by means of the first activity that the Federal Reserve is able to manipulate the total amount of credit (what we now use as “money”) that is available in the economy. It does this by expanding or contracting its “balance sheet”.  For every security stored inside the Fed’s balance sheet … and paying interest to the Treasury … after the Fed takes its cut … someone else has a large amount of credit to spend on something.  The Fed creates credit “ex nihilo” – out of nothing.  A mighty power, which is why the Fed Chairman is frequently described as the most powerful man in the nation.

Those claiming that the Fed is a fictitious organization often point out that short term interest rates lead the Federal Reserve’s policy target rate. The market leads and then the Fed follows, right?  Well, the Fed does have to react when short term rates pressure the bounds of the policy target, because otherwise rates would go where the Fed doesn’t want them to go. But ask yourselves — how many folks spend thousands of hours each year trying to figure out where the Fed wants rates to go, and get there first? The market is doing the Fed’s bidding because that’s where the money is. What actually happens is that the Fed telegraphs to the market which way the rate is about to go — or the market has figured out where the Fed will be telegraphing, and has front-run them, which amounts to the same thing but yields more profit for the banksters.

Now, if the Fed can convince the market where it wants the market to go, and the market goes there, it’s a lot less work for the Fed.  And thus a lot less expensive. But there are times when the Fed has to take the market by the horns and implement massive adjustments.  This is part of what happened in 2008-2009. Sometimes the Fed dances with the market, and sometimes the Fed picks the market up bodily and shoves it into place…

But back to the standard operating procedure: the main tool is the policy press release issued at each Fed meeting, which typically reveals (in a few words) the Fed’s outlook for short-term rates. Secondary tools are the minutes released between the meetings, the “Beige Book” economic analysis, and also the public speeches which are frequently given by the various Fed members.  Each of these helps to set the market’s expectations of future policy.  Conversely, the market also communicates with the Fed, by way of current interest rate pressures (relative to the current Fed target rate) and prices in the rate futures markets.

Now, which is more powerful?  The market would always go where the Fed leads it, unless it believed the Fed were fully able to implement its targets.  On the one side, the Fed’s ability to drain credit from the market (by selling assets on its balance sheet and siphoning cash out of the system) is a potent, but not omnipotent, lever for raising interest rates.  By shrinking the supply of short-term credit, the Fed can fully offset private-sector increases in credit, and force short-term rates upwards.  This generally moves the long-term rates up as well — who wants to lend long when short rates are paying more, and less risky?  But sometimes the market is in full fraudulent bubble mode, in which case the Fed can force up short-term rates, but long-term lending supply doesn’t respond immediately, and rates fail to respond — as Greenspan’s “conundrum” showed in the 2004-2007 tightening cycle.

On the other side, by expanding the supply of short term credit, the Fed can fully offset just about any private-sector decrease in credit, and force rates downwards. And again, drops in short rates tend to result in drops in long rates, as yield-seeking borrowers are forced to make longer commitments (and thus take on more inflation risk).  This again can fail (or at least take a long time) when the market is in full panic mode, in which case the Fed can also force down long-term rates by purchasing long-term securities.  (But as Bernanke is now experiencing, even after buying up over $1 trillion in fraudulent mortgage securities and flooding the banks with enough cash to give nearly $3,000 to every man-woman-and-child legally in the country, the Fed can force short term rates to zero, and it can pull 30-year rates under 5%, but it still can’t make  creditworthy borrowers out of overindebted individuals and institutions, nor can it make others lend for 30 years in a climate bordering on hysteria over long-term fiscal/policy stability questions…)

So which is more powerful?  From 2004-2008 we saw the market bubble with low long-term rates, despite (belated) Fed efforts to raise rates.  In 2008-2009 we saw the market panic with a total credit freeze (infinite rates – no credit at any price!) in many parts of the market. But we also saw the Fed go thermonuclear and force short rates to zero and long rates to record lows.  So in the short term, the Fed is more powerful.

But in the long term, the actions of the Fed have economic and political consequences. Buying up Treasuries is seen as printing money and enabling Congressional waste.  Buying up mortgage securities is not only probably illegal (based on a tight reading of the Federal Reserve act and the legal technicality that Fannie & Freddie debt is not “full faith and credit” debt of the U.S.), but also has political consequences as people begin to realize that fraudulent lending is “crime that pays”.  Some of those political consequences lead to “Audit the Fed” movements and other political pressures, and those in turn remind us that in the end, the Federal Reserve is only as powerful as Congress allows it to be.

But remember to watch what the Fed actually does!  It’s the Temporary and Permanent Open Market Operations that matter!  And the alphabet soup of lending programs.

And finally:  A more transparent Fed would go a long way toward cleaning up the Augean Stables of American Finance, and while that would be painful for us all in the short term, in the long term, accurate and transparent national accounting is vital to restore investor confidence in security of prinicipal and reasonable rates of return, on investments one can be proud of.