Wednesday, January 27, 2010

The Fed cannot inflate. Buy Bonds.

Ben Bernanke is famous for saying that the Fed can always inflate if needs be by "dropping money from helicopters".

But the Fed cannot "drop money from helicopters". Only the Treasury can. Helicopter drops of money are fiscal policy, not monetary policy, as they create net new financial assets for the non-Govt sector. The Fed cannot inflate.

If you think about the mechanisms the Fed has, it becomes clear that they do not have to tools to create inflation. They can control interest rates, but rates are a double edged sword as the non-Govt sector has both borrowers and lenders. Low rates help borrowers but hurt savers, and high rates do the opposite. At a sector level, the impact of interest rates is muddled at best, there certainly is no clear mechanism to generate inflation.

The Fed can also alter the level of bank reserves. If banks lent out reserves, this might have some impact on private sector credit expansion, but as banks do not lend out reserves, it does not. There's been a long debate in various blogs about whether, on the margin, a vast sea of reserves might have some impact on bank behavior, but nothing definitive came out of it. As a mechanism, it's weak.

The only thing left is belief, something that Nick Rowe came very close to admitting in a post a few months back. "Monetary policy does not actually work, but if people believe it works, it might". There you have it, Fed as Placebo. I think much of the runup in the S&P has been based on two things: 1) cheap labor (which helps corporate profits) and 2) a belief that the Fed will get the economy restarted. If 2 weakens, then all that's left is unemployment to enrich corporations by helping their bottom line, but there is no demand to help them grow their top line. It's a very ugly scenario, and one that Japan's been enjoying for about 20 years now.

The Obama administration's recent moves to cap deficits means that the hawks have taken control of that, and the Government will stop creating the net financial assets that the private sector so desperately wants. This will put a ceiling on aggregate demand, Another equity downleg and it may be all over.

I blame Robert Rubin. I met him many years ago at U Chicago, and he was intelligent, articulate, and completely different from then Treasury Secretary Snow who begged us to ask him about his Africa trip with Bono because he didn't understand any of the derivative regulation questions we were peppering him with. The Clinton gang, in particular Rubin, believe that the Clinton surpluses were what generated the boom the US enjoyed in the 90s. That is the driver for Obama to get tough on the deficit. In reality, of course, the Clinton surpluses dramatically increased the fragility of the private sector by draining it of savings, leaving it more levered BEFORE the Greenspan orchestrated real estate bubble. The dot com asset bubble, and various other lukcy drivers of aggregate demand papered over this increasing fragility, but sector level balance sheets don't lie. At any rate, Rubin learned the wrong lessons from that episode, and Obama is setting the economy up for a 2010 that will either be bad or worse.

Even at 3% (or whatever) I recommend you buy Treasuries.


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