The Problem with a Staged Fed Retreat

Get out your tea leaves — it’s that time again.

“On Tuesday and Wednesday,” writes John Beveridge at the Herald Sun, “Bernanke and his board will discuss their next step as they try to engineer a staged retreat from some of the most extraordinary money printing stimulus the U.S. has ever seen.”

Once again, Wall Street will hang on each word with nauseating myopia trying to determine if infinite quantitative easing will soon become finite.

That’s the problem with a staged retreat: Everyone’s watching for it and reacts accordingly.

“Last month” Beveridge continues, “when Bernanke told Congress he was thinking about starting to wheel the punch bowl toward the kitchen if things kept going well, the party began to get out of hand. Markets and currencies gyrated as they considered what would happen if the U.S. Fed scaled back its program of buying $85 billion of government bonds every month.”

Our macro strategist Dan Amoss lays out the play-by-play in his Strategic Short Report:

“A key plank of the Fed’s exit strategy involves paying higher interest rates on excess reserves. This would have the effect of keeping the huge stock of recently printed money on deposit at the Fed, preventing it from entering circulation out in the real economy.

“While that may sound fine in theory, here’s the political problem: The Fed would wind up paying hundreds of billions of dollars in interest payments on its liabilities — after it has already locked in low rates on its assets by buying low-yielding Treasuries and mortgage securities. Like a bank in a flat yield curve environment, the Fed’s net interest income would vanish — along with its annual remittances to the Treasury. These remittances have cut the U.S. Treasury’s financing burden by hundreds of billions of dollars since 2008…

“If the Fed loses the ability to pay interest on excess reserves (which Congress granted in the 2008 crisis), it will have to use much more painful ‘open market operations.’ Tightening policy using open market operations would involve selling Treasuries and mortgages into a collapsing, bidless bond market while erasing previously printed base money supplies. You can imagine what a disaster this would be for the prices of all ‘risk’ assets. The rush to sell everything (stocks, bonds, real estate) would be unprecedented.”

That’s why we figure that Wall Street’s palm readers will be left guessing after the Fed announces.

Mortgage rates have already spiked just above 4% last week and our credit addiction hasn’t really changed.

Below you can see what consumer debt looks like.

It’s dropped by about $1.2 trillion from a high of $14 trillion in 2008, but that doesn’t mean we’re out of the woods:

Households and nonprofit organizations; credit market instruments, liability

Moreover, total debt across all sectors has risen to almost $60 trillion…almost 4 times the nation’s income.

All Sectors

Ironically, former Fed chairman Alan Greenspan explained in these pages last week why such a debt kick is like dancing on the ledge:

“The comparable measure with respect to households is that if you don’t save adequately, you are wholly dependent upon the income you are getting. But as far as you’re concerned, unless you put money away for nest egg purposes, for retirement, for a variety of other purposes, you will find that you are living an extraordinarily precarious existence. Savings is the buffer which is the gap between disaster and prosperity.”

“Gosh,” one reader commented after reading those words. “He espouses Austrian principles before and after he’s the head of the Federal Reserve. And our leaders try to have us believe that the institution isn’t politicized?”

Indeed,

Peter Coyne
for The Daily Reckoning

Ed. Note. Preceding an exceptional piece by none other than Dr. Ron Paul, this piece was originally featured in the Daily Reckoning email edition — an issue that took a closer look at the perils of paper money. And Dr. Paul even recounted an amusing exchange with former Fed Chairman, Alan Greenspan, confirming his seemingly dual personality. All that in one neatly compiled email, sent straight your inbox… absolutely free. If you’re not already receiving the Daily Reckoning email edition, check it out for free, right here.