The Fiscal Fed

The economist who gained recognition for predicting the global credit crisis, Nouriel Roubini, also known as Doctor Doom, in a recent column mistakenly invoked an astrological sign when he called Argentina's capital city Buenos Aries, instead of Aires.

Bringing to mind this quote from economist John Kenneth Gailbraith, that the "only function of economic forecasting is to make astrology look respectable."

A timely notion, given that Federal Reserve officials are now in open dissension about whether they can really properly forecast the impact on the economy and the markets of the Fed's stoking of the liquidity furnace with an alphabet's soup of lending programs and the gargantuan inflation of its balance sheet.

That includes the central bank's decision to help monetize the open fire hydrant of government deficit spending.

The Federal Reserve is meeting next week from June 23nd to June 24^th.

On the table are key issues with dramatic significance to you and your money.

Any hints by Fed officials that it might either stop buying Treasurys to keep rates low, or yank its generous liquidity support would run the risk of pushing bond yields higher, which, along with higher oil prices, would threaten the recovery of the US as well as world markets.

However, worries about a Fed interest rate hike to choke off a possible inflationary spiral were likely put off, for now, with a new consumer price report that show prices fell 1.3% from a year earlier, one of the biggest drops since the '50s. The futures market had expected the Federal Reserve will start raising rates as soon as the final quarter of this year.

But Fed chairman Ben Bernanke is not a magician who can wave his liquidity wand and all will be well.

If the central bank doesn't get the plumbing right, the US risks a double dip recession, or a nasty bout of inflation in a few years' time, just when taxes are about to go higher. 

Fed Taking on Water

Given that monetary policy is less effective when interest rates are zero, the Fed has been blowing its economic circuits to stop the mayhem in the credit markets with new lending programs.

With a balance sheet that's doubled in a year's time to $2 tn, the Fed, for the first time since the late '40s, is on track to buy $300 bn worth of Treasurys and $1.25 tn in Fannie Mae and Freddie Mac securitizations (the Fed started to buy one-year Treasurys in 1947 to help the government pay for World War II).

Mortgage and other loan rates are tied to 10-year Treasurys, and when there are no buyers, or there's competition from a bond glut, yields rise in order to lure investors. Loan rates then rise, too.

The Fed has been buying Treasurys to keep yields low, and it's purchasing Fannie and Freddie securitizations of mortgages to defrost the lending markets.

Though this is wartime finance without the war, as one analyst notes, Bernanke is winning praise for his innovative, bold programs and his attempt to help keep consumer loan rates low.

But the Fed has also invested in all sorts of dodgy assets to help rescue AIG, Bear Stearns, as well as toss lifelines to Fannie Mae and Freddie Mac, making the central bank the world's biggest junk investor. The Fed has lost $5.5 bn on those assets, recent marks in its financials show.

If the Fed was a regular commercial bank (it's acting like one, so why didn't the central bank replace Citigroup in the Dow 30?), its own thin wedge of a capital cushion, maybe $100 bn so, which supports a $2 tn balance sheet, makes it questionable whether it would have passed the Treasury's own stress tests?

And by wading deeper into the political minefield of US fiscal policy, by starting to monetize the government's gusher of deficit spending, a gusher that threatens to tear a hole in universe, the Fed is exacerbating inflation fears, fears that, ironically may undo the Fed's work to keep consumer loan rates low.

Bond Market Expectations

Watching the river of Treasurys and the Fed's purchases of bonds, bond traders are starting to demand higher bond yields to cover what they expect in the way of higher inflation. Higher bond yields that, in turn, will push interest and mortgage rates higher.

Perceptions become reality. If the bond market expects the Fed to keep wading deeper into fiscal policy--meaning, helping the country to inflate away its problems--will it demand ever higher bond yields?

A key controversy to watch now, especially given the spending spree the Dems are now on to stimulate the economy, spending which now seems more like drinking Scotch to cure a hangover, as one analyst up it.

And will the prospect of 10% unemployment on Election Day 2010 prompt the Democrats to push through yet another round of fiscal stimulus, or another set of corporate bailouts, meaning more spending pressure on the Treasury and the Federal Reserve? The Fed is expected to recast its unemployment estimates higher to 9.5% at its meeting next week, from  9%, the highest rate in 26 years.

Congress will do Stim 2.0, Stim 3.0, whatever it takes to get reelected.

When companies fail governments get bigger. When governments fail, governments get bigger. 

Fed Officials In Open Debate

The Federal Reserve isn't capable of offsetting the "flood" of U.S. Treasury borrowing with its bond-purchase program, which is helping to revive credit markets, Dallas district-bank President Richard Fisher said this week.

San Francisco Federal Reserve president Janet Yellen also weighed in with criticism recently, noting that, while the Fed's Treasury and debt purchases got off to a good start with yields heading lower, "there's a lot that central bankers don't know about the magnitude and duration of the effects of these policies," adding, "we lack both the data and theory to provide strong guidance on these policies" and "we are sailing in uncharted waters."

And when it comes to pulling the liquidity punch bowl by hiking interest rates, market officials note that Fed chairman Bernanke hasn't been tested yet on this side of the monetary mountain--and his term expires in January 2010.

The Fed under Bernanke has overseen the largest increase in the monetary base in the past fifty years by a factor of ten, notes economist Art Laffer.

The Bernanke Heads Up

Bernanke gave the world markets the heads up that he would open the taps big-time if needed when he apologized seven years ago on behalf of the US central bank, acknowledging that its actions helped cause the Great Depression.

On economist Milton Friedman's 90th birthday in 2002, Bernanke noted that the US central bank hastened America's economic decline in the Great Depression when it carved a third out of the money supply from 1929 to 1933.

Bernanke said: "Regarding the Great Depression. You're right, we did it. We're very sorry."

Government Spending Derails

But it's not just the Federal Reserve that has gone full bore.

The Administration has now put on the back of taxpayers and entrepreneurs gargantuan spending plans equal to the gross domestic product of Japan, as it holds fast to the habitually self-deceiving belief that massive increases in public debt and spending can replace lost private sector debt and consumer spending cutbacks. 

Health care reform will blow out those deficit sums even more.

Notice how the president, in his recent speech before the American Medical Association, didn't mention LBJ when he talked about prior presidents who have tried to tackle health care reform, going back to Teddy Roosevelt, because doing so would bring up out of control Medicare spending.

Notice that the president did not talk about immigration reform, as California and Arizona teeter on the brink paying for health care costs for illegal immigrants. And tort reform to handle a blitz of malpractice suits was given short shrift.

This administration cannot reform health care without immigration and tort reform. Because if it doesn't make these changes, its health care reform will come freighted with exponentially higher costs, costs it will put right onto the backs of US taxpayers.

Return of Voodoo Economics

For the administration to argue that the health care industry's promised cost savings of $1.5 tn or more will help pay for health care reform is simply the left's version of voodoo economics, says analyst Tyler Cowen (invoking a term former President George H.W. Bush used against President Ronald Reagan's supply-side economics agenda).

"Promises of health care cost control have turned into the Laffer Curve of the left: a way to pretend that their favored policies don't have any costs," says Megan McArdle of Atlantic Magazine's Business Channel.

McArdle adds: "We have been trying to control health care costs since the 1970s made it clear that Medicare was going to get really, really expensive.  And any idea that you care to name, from comparative effectiveness research to healthcare IT to preventive medicine...these have all been on the table for more than thirty years, under one name or another." Health costs control hasn't "happened," McArdle adds.

Deficit Blow Out

The credit ratings agency Standard & Poors said it is unlikely that it will lower its triple A rating on the US government in the near term.

But that doesn't mean the US's deficit spending is not on the radar screen at the ratings agencies. 

So far for 2009, the US has a budget deficit of $991.95 bn, more than double the entire 2008 deficit of $454.8 bn. The Democrats have passed a $3.6 bn budget, $787 bn in stimulus spending, have spent over $180 bn on TARP investments and over $70 bn for jobless benefits.

Interest on the public debt has hit more than $145 bn, the equivalent of the annual budget for about a dozen federal agencies. Meanwhile, Social Security and Medicare unfunded liabilities continue to mushroom, tens of trillions of dollars worth.

US Treasurys are now competing with debt issuances from governments around the world. About $11.7 tn in new debt will be issued in the international markets this year, compared with $10.6 tn last year. But Barclays Capital says the Fed needs to buy more than $1 tn in Treasurys to keep consumer loan rates low.

"We can all picture the visual of Bernanke in the swimming pool doing his best to keep that beach ball (interest rates) under water," notes economist Peter Morici.

The USA's Systemic Risk Regulator: Bond Vigilantes

Some recent, dicey Treasury auctions have Wall Streeters warning that the bond market is testing the credibility of the Fed. Treasury yields have risen on some of these auctions, suggesting investors are demanding inflation premiums.

The only adult supervision the US government has on its spending are the bond vigilantes.

And this is a crowd the Administration doesn't want to mess with. Economist Edward Yardeni notes the bond vigilantes nearly wrecked the US recoveries in the '80s and '90s when they demanded inflation premiums on Treasurys.

The biggest bond vigilante of all being China, as it finger wags the US for its profligacy, as it rotates out of buying Treasurys, as credit default swaps on US sovereign debt are now pricier than those for McDonald's, Bristol Myers Squibb and Campbell Soup.

China fears the US's spendthrift ways will eventually inflate away the value of its U.S. bond holdings and slam the dollar. And it's likely right.

Has the Market's Reality Check Bounced?

At 3.86% recently, the 10-year Treasury yield is the highest since November 3, but it's still lower than the 5% level they were at just before Lehman and AIG "hit the fan in mid-September 2008," notes economist Yardeni.

The recent jump in bond rates is likely a desirable normalization after the panicked, worldwide rush into Treasurys drove yields down to microscopic levels of 1% to 2%.  

Mortgage rates, though rising since hitting a low of 4.7% in May, are still historically low. Mortgage bond yields are down from hitting a 5.07% high on June 10th, the highest level since the Fed debuted plans to buy Fannie and Freddie securitizations bonds in November.

The yields on corporate bonds are well below levels seen at the end of last year, calling into question the idea that the government's issuances will crowd out private sector borrowing in a deep recession.

Credit markets are easing up. Credit quality spreads for junk and triple A corporate bonds, after peaking on December 31 and March 18, respectively, are dropping.

Credit quality spreads for junk are down from 2070 basis points to 981 basis points. Credit quality spreads for triple A corporates are down from 300 basis points to 200 basis points, Yardeni says.

But is this defrosting in the credit markets a head fake? Are Treasury yields holding steady simply because there's been a worldwide flight to quality, because no one wants to invest in Japan or Europe's debt?

And how much is the FDIC's guarantee of corporate debt helping to keep corporate yields artificially low?

The question on Wall Street's mind is, has the Fed's monetary policy created another bubble--whether it's consumer price inflation or asset price inflation or something else?

Fed's Exit Strategy May Trigger Double Dip Recession

The Fed will soon have to start mopping up the trillions of dollars of its unprecedented emergency liquidity that it pumped into the economy to heal the system, in order to ward off a vicious inflation spiral.

To reverse quantitative easing, and to shrink the Fed's balance sheet, one thing the government would have to do is sell bonds.

Selling bonds essentially removes the excess cash in the system. You replace the cash in the system with a bond.

But doing so would create an ensuing bond glut, a bond glut that would compete with the Treasury's own issuances.

All those Treasury bonds competing with each other, and with bonds overseas, would cause bond yields to rise and concomitantly would cause interest rates to increase.

To pay for higher interest costs, the government would have to slash its spending, just as Japan did in 2006 when it last exited out of its quantitative easing program to fix its zombie decade.

That means the US economy would face a double-down tightening due to higher interest rates and lower government spending.

Separate from that, when you contract the monetary base by removing cash, that also means a contraction in bank lending.

Put together, all of this spells one thing: A double-dip recession. Which is what economist Roubini now says we can expect.