Trump's Historic Opportunity with the Federal Reserve

09/07/2017Tho Bishop

And then there were three.

Today Stanley Fischer submitted his letter of resignation from the Federal Reserve’s Board of Governors, effective next month, the second such resignation of Donald Trump’s presidency. While Fischer’s term as Vice Chairman of the Fed was set to end next year, he had the ability to serve as a governor through 2020. Along with Trump’s decision next year on whether to replace Janet Yellen as the Fed’s chair, this means Trumps will have the opportunity to appoint five of seven governors to America’s central bank.

Given that the position holds a 14-year term, it is unusual for a president to have the opportunity to make so many appointments. As Diane Swonk of DS Economics noted, “It’s the largest potential regime change in the leadership of the Fed since 1936.”

Of course the question is now whether a change in personnel will lead to a change in policy.

Trump has already taken steps to fill one of the vacancies, nominating Randal Quarles earlier this year. Quarles, a former Bush-era Treasury official turned investment banker, will be taking the specific role of Fed vice chair of supervision. As a vocal critic of Dodd-Frank, and the Volker Rule in particular, Quarles may help relieve some of the regulatory burden on financial institutions, but his views on monetary policy are less clear. He has also voiced his support for rules-based monetary policy, though he has distanced himself to the specific proposal of the “Taylor Rule.” Given the growing consensus building for NGDP-targeting, and Republicans in Congress advocating for rules-based Fed reform, Quarles could become a supporter from within the central bank. All in all though, Quarles is seen by many observes as a bland Fed-appointment.

More concerning are the views of Marvin Goodfriend, who has been reported to be a front runner for one of the Fed vacancies. An economics professor at Carnegie Mellon University and former director of research at the Richmond Fed, Goodfriend has a traditional central banker background and the dangers that comes with it. In 2016, Goodfriend made an impassioned plea for the Fed to consider negative-interest rates:

The zero interest bound is an encumbrance on monetary policy to be removed, much as the gold standard and the fixed foreign exchange rate encumbrances were removed, to free the price level from the destabilizing influence of a relative price over which monetary policy has little control—in this case, so movements in the intertemporal terms of trade can be reflected fully in interest rate policy to stabilize employment and inflation over the business cycle.

Since negative interest rates usually coincide with greater use of cash (and personal vaults), Goodfriend went so far as to suggest the Fed should consider devaluing the value of printed bank notes. A $10 bill would buy less than a $10 debit card transaction, opening up a new front in the ongoing war on cash.  

Given his radical views on monetary policy, it’s not hyperbole to suggest that Goodfriend’s nomination would represent a genuine danger to the economic wellbeing of every American citizen – or at least those outside of the financial services industry.

Unfortunately, even if Goodfriend doesn’t get the nod, it’s unlikely Trump will nominate anyone who understands the negative consequences of our artificially low interest rate environment. Though Candidate Trump demonstrated remarkable savvy when it came to how the actions of Bernanke and Yellen hurt Americans, as President Trump he has consistently indicated a desire to keep the “big fat bubble” going. Such a desire obviously fits the self-interest of the White House, but with long-term consequences for the base that elected him.

The only hope for a change in direction from the Administration is for Trump to stop listening to his Goldman Guys and instead lean on the team that helped get him to the White House. As Tommy Behkne noted last November, Trump had managed to surround himself with a number of Fed skeptics during his campaign, and even considered Austrian-friendly John Allison for Treasury Secretary.

Given the historic opportunity he has with the Fed, if Trump chooses to return to those roots, he could do severe damage to the swamp — all without passing a single piece of legislation through Congress.

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The Rise of Zombie Companies — And Why It Matters

08/08/2017Daniel Lacalle

The Bank of International Settlements (BIS) has warned again of the collateral damages of extremely loose monetary policy. One of the biggest threats is the rise of “zombie companies.” Since the “recovery” started, zombie firms have increased from 7.5% to 10.5%. In Europe, Bof A estimates that about 9% of the largest companies could be categorized as “walking dead.”

What is a zombie company? It is — in the BIS definition — a listed firm, with ten years or more of existence, where the ratio of EBIT (earnings before interest and taxes) relative to interest expense is lower than one. In essence, a company that merely survives due to the constant refinancing of its debt and, despite re-structuring and low rates, is still unable to cover its interest expense with operating profits, let alone repay the principal.

This share of zombie firms can be perceived by some as “small.” At the end of the day, 10.5% means that 89.5% are not zombies. But that analysis would be too complacent. According to Moody’s and Standard and Poor’s, debt repayment capacity has broadly weakened globally despite ultra-low rates and ample liquidity. Furthermore, the BIS only analyses listed zombie companies, but in the OECD 90% of the companies are SMEs (Small and Medium Enterprises), and a large proportion of these smaller non-listed companies, are still loss-making. In the Eurozone, the ECB estimates that around 30% of SMEs are still in the red and the figures are smaller, but not massively dissimilar in the US, estimated at 20%, and the UK, close to 25%.

The rise of zombie companies is not a good thing. Some might say that at least these companies are still functioning, and jobs are kept alive, but the reality is that a growingly “zombified” economy is showing to reward the unproductive and tax the productive, creating a perverse incentive and protecting nothing in the long run. Companies that underperform get their debt refinanced over and over again, while growing and high productivity firms struggle to get access to credit. When cheap money ends, the first ones collapse and the second ones have not been allowed to thrive to offset the impact.

Low interest rates and high liquidity have not helped deleverage. Global debt has soared to 325% of GDP. Loose monetary policies have not helped clean overcapacity, and as such zombie companies perpetuate the glut in many sectors, driving down the growth in productivity and, despite historic low unemployment rates, we continue to see real wages stagnate.

The citizen does not benefit from the zombification of the economy. The citizen pays for it. How? With the destruction of savings through financial repression and the collapse of real wage growth. Savers pay for zombification, under the mirage that it “keeps” jobs.

Zombification does not boost job creation or buy time, it is a perverse incentive that delays the recovery. It is a transfer of wealth from savers and healthy companies to inefficient and obsolete businesses.

The longer it takes to clean the overcapacity — which stands above 20% in the OECD — and zombification of the economy, the worse the outcome will be. Because, when the placebo effect of monetary policy disappears, the domino of bankruptcies in companies that have been artificially kept alive will not be offset by the improvement in high added-value sectors. Policymakers have decided to penalize the high productivity sectors through taxation and subsidize the low productivity ones through monetary and fiscal policies. This is likely to create a vacuum effect when the bubble bursts.

The jobs and companies that they try to protect will disappear, and the impact on banks’ solvency and the real economy will be much worse.

Avoiding making hard decisions from a crisis created by excess and overcapacity ends up generating a much more negative effect afterward.

Reprinted with permission of the author. Daniel Lacalle has a PhD in Economics and is author of Escape from the Central Bank TrapLife In The Financial Markets, and The Energy World Is Flat (Wiley).

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This Time, It's a Bubble in Rentals

08/04/2017Doug French

Sin City’s projected 5,000 new apartment units for this year makes no noise nationally in the latest real estate craze. “In 2017, the ongoing apartment building-boom in the US will set a new record: 346,000 new rental apartments in buildings with 50+ units are expected to hit the market,” writes Wolf Richter on Wolf Street. That is three times the number of units that came on line in 2011.

Richter continues, “Deliveries in 2017 will be 21% above the prior record set in 2016, based on data going back to 1997, by Yardi Matrix, via Rent Café. And even 2015 had set a record. Between 1997 and 2006, so pre-Financial-Crisis, annual completions averaged 212,740 units; 2017 will be 63% higher!”

I’ve written before about the high-rise crane craze in Seattle, but that’s nothing compared to New York and Dallas, that are adding 27,000 and 25,000 units, respectively. Chicago is adding 7,800 units despite a shrinking population and rents decreasing 19 percent.


Not surprisingly, Fannie Mae and Freddie Mac are financing this rental housing boom. I wrote recently, the GSEs made 53% of all apartment loans in 2016, down from their combined 68% market share in 2012. “So, their conservator, The Federal Housing Finance Agency (FHFA), recently eased the GSE’s lending caps so they can crank out even more loans.”

Mary Salmonsen writes for multifamilyexecutive.com, “Currently, Fannie and Freddie are particularly dominant in garden apartments [and] in student housing, with 62% and 61% shares, respectively. The two remain the largest mid-/high-rise lenders but hold only 35% of the market.”

Mr. Richter warns us, “Government Sponsored Enterprises such as Fannie Mae guarantee commercial mortgages on apartment buildings and package them in Commercial Mortgage-Backed Securities. So taxpayers are on the hook. Banks are on the hook too.”

But, for the moment, it’s build them and they will come; first renters, then complex buyers. Wall Street giant “The Blackstone Group acquired three Las Vegas Valley apartment complexes for $170 million, property records show,” writes Eli Segall for the Las Vegas Review Journal. “Overall, it bought 972 units for an average of $174,900 each.”

Sales like this has developers going as fast as they can. I heard an apartment developer say Vegas has at least four more good years left in this cycle and is scrambling for new sites. In the land of Starbucks, Microsoft and Amazon, it’s thought the boom will never end. Richter writes, “the new supply of apartment units hitting the market in 2018 and 2019 will even be larger. In Seattle, for example, there are 67,507 new apartment units in the pipeline.”

However, while no one was paying attention, “the prices of apartment buildings nationally, after seven dizzying boom years, peaked last summer and have declined 3% since,” Richter writes. “Transaction volume of apartment buildings has plunged. And asking rents, the crux because they pay for the whole construct, have now flattened.”

As usual, cheap money entices developers to over do it, and the fall will be just as painful.

Douglas French is former president of the Mises Institute, author of Early Speculative Bubbles & Increases in the Money Supply, and author of Walk Away: The Rise and Fall of the Home-Ownership Myth.

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The Fed Gave Wall Street a Bomb, and the Taxpayers are Paying Ransom

08/02/2017Tho Bishop

When Janet Yellen testified before the House Financial Services Committee last month, she faced grilling on a topic that hasn’t received enough mainstream attention: the interest being paid on excess reserves at the Fed. While the topic has come up occasionally since the program began in 2008, it is worth noting that Yellen was pushed by both Jeb Hensarling, the committee chairman, and Andy Barr, the chairman of the Monetary Policy Subcommittee. While ending this taxpayer subsidy to Wall Street is important, it’s also important to understand the dangers posed by allowing these excess reserves to be lent out of major financial institutions.

RELATED: "Who Benefits from the Fed?" by David Howden

fred monetary base.png

To understand what is at stake, recall back to 2008 when many Fed observers were concerned about the inflation dangers posed by the policies of the Bernanke Fed. In a six year period, the base money supply increased over four-fold. Understandably, this sparked grave fears about the devaluation of the dollar — fears that, to date, have yet to really present themselves in the CPI. While stock prices, real estate prices, and other types of asset-price inflation are likely being fueled by this monetary policy, the Fed isn’t facing political pressure from inflation concerns — but rather being grilled by misinformed legislators for not reaching their (unfortunate) 2% inflation target.

fred excess reserves.png

This is, in part, due to the fact that a lot of this new money has been kept sterile by being parked within the Fed itself as excess reserves. Today, more than $2 trillion worth of these reserves are parked at the Fed, which means that only two thirds of the newly created money has actually been pumped into the “real economy.”

RELATED: "Central Banks Should Stop Paying Interest on Reserves" by Brendan Brown

Now this policy should rightfully puncture the narrative that the Fed was at all concerned with providing liquidity to businesses on Main Street (i.e., not big banks). After all, if the aim of the various rounds of QE was to get banks to loan, then paying them not to is irrational. Instead, the Fed was using taxpayer dollars to subsidize the very same banks that they just bailed out. We are continuing, to this day, to pay banks to not make loans. 

While Bernanke repeatedly dismissed the problem of incentives posed by paying 25 basis points on these reserves, the reality is that this was a risk-free investment at a time of great market volatility. Considering that several important banks had issues passing the Fed’s stress tests — tests are designed to exaggerate the stability of the financial sector — it doesn’t require a great logical leap to suggest that the Fed misrepresented this program to public in the name of “stabilizing” the financial sector. In 2016, this policy paid $16 billion to big banks, a number that will likely rise as the interest rate payments go up with every increase in the federal funds rate (we are now paying 1.25% interesthigher than the public can receive from their own banks.)

While both the public and Fed critics on Capitol Hill should be outraged at this clear example of cronyism, simply ending it is not enough. After all, the danger of refusing to pay ransom money is that the ransomer will follow through on their threat. If the Fed was to simply stop payment on these funds, and banks decided to lend it out — then $2 trillion would be injected into credit markets. Given the amplifying effects of a fractional reserve banking system, it’s easy to see how quickly this could unleash severe inflationary pressures.

So this is the true policy issue going forward, how do you stop the taxpayer subsidy to Wall Street while avoiding lighting the fuse to Bernanke’s inflation bomb? One way would be to increase reserve requirements. Currently banks with over $115.1 million in liabilities have to keep 10% at the Fed, by raising that number up you will not only serve to keep this expansion of the monetary base “sterile,” but will make the banking sector as a whole more stable.

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The Fed Remains on Course – to Trouble

The Federal Reserve (Fed) is widely expected to continue to tighten its monetary policy this year. According to a latest Reuters Poll, the Fed is likely to start shrinking its US$4 trillion balance sheet in September and, moreover, raise further its key interest rate, which is currently standing in a range of 1.0 to 1.25 percent, in the fourth quarter this year.

According to mainstream economic wisdom, the time has come for the US economy to return to a more normal level of interest rates. Industrial output is expanding at a decent clip, official unemployment has declined markedly, and prices in the stock and housing market show a sustained upward drift. Considering these circumstances, the US economy can now shoulder a tighter monetary policy, it is said.

It should be understood, however, that there will be side-effects, even unintended consequences, if and when the Fed hikes interest rates further. Most importantly, the Fed doesn’t know where the “neutral interest rate” is. If it does too much, the economy will collapse. If it does not do enough, it will only prolong the artificial boom, causing ongoing malinvestment and, ultimately, another crisis.

Admittedly, this is nothing new: The Fed has always been a cause of boom and bust. It sets into motion an artificial boom by issuing new fiat money through bank credit expansion. Such a boom, however, must sooner rather than later collapse and turn into a bust. It is, therefore, strongly advised to expect nothing good coming out of Fed interventions.

Going Through the Numbers

This of course holds true for the Fed’s plan to start selling securities it has bought during the financial and economic crisis to prop up the economic and financial system. Back in 2008 and 2009, the Fed provided the US banking system with an enormous cash infusion by granting loans to and purchasing securities from banks.

The Fed ramped up banks' cash holdings from US$ 24,9bn to US$ 2,398.1bn from September 2008 to July 2017. It did so by buying Treasuries and mortgage-backed securities (MBS) amounting to US$ 1,908.9bn and US$1,770.3bn, respectively. In the meantime, however, banks have repaid most of the loans provided by the Fed.

This, in turn, has reduced banks' cash holdings to US$ 2,398.2bn. As a result, it has become impossible for the Fed to sell all the bonds it has purchased. Simply put: The US banking system does currently not have enough base money to pay for the Fed’s crisis-related bond purchases of US$3.755.8bn.


If the Fed were to shed just 64 percent of its current bond holdings, the base money supply in the US banking system would be completely wiped out, making the banking sector effectively illiquid. In this process, US interbank interest rates would presumably spike, sending shock waves through the economic and financial system, not only in the US but worldwide.

Three Options

It is safe to assume that the Fed and the banks would want to avoid such a scenario. This leaves the Fed with three options. Option 1: The Fed sells only a (small) part of its current Treasury and MBS to avoid a liquidity shortage in the interbank money market. In other words: The Fed would have to keep sitting on a significant part of its bond holdings and buy new bonds once they mature.

Option 2: The Fed sells off its bond holdings and, at the same time, runs liquidity providing operations to keep banks sufficiently equipped with cash. It purchases, for instance, consumer and/or corporate loans from banks issuing new base money. As a result, the Fed’s assets in its balance sheet would see Treasuries and MBS go down, and consumer and corporate loans go up.

Option 3: The Fed swaps its Treasury and MBS holdings into short-term maturities and sells these papers over time, thereby reducing the base money supply in the banking system as far as possible. This way, the Fed would reduce its active involvement in the credit markets somewhat, confining it mainly to the short-term end of the market.

Interest Rates will Remain Distorted

That said, it will be enlightening to see which option the Fed will ultimately choose. Option 1 and 2 would be indicative of the Fed wanting to retain its powerful grip on the price action and consequently the yields in fixed income markets. Option 3, in turn, would suggest that the Fed allows interest rates in the long-term end of the market to normalize at least to some extent.

Whatever option it chooses, however, the Fed will, one way or another, keep distorting interest rates. By issuing new quantities of fiat money through credit expansion, the Fed inevitably wreaks havoc on the economy's price system. It manipulates the perception of risk and flatters the value of future cash flows.

This, in turn, causes many economic and social problems. Most importantly, the Fed’s actions debase the purchasing power of the US dollar, thereby destroying much of peoples' life savings. What is more, the Fed’s policy coercively redistributes income and wealth, and it also brings about costly boom and busts.

Just to be on the safe side: The Fed is not the solution to all these problems. It is the actual cause. Whatever the US central bank will do: Be assured it will remain on course to trouble. And trouble there will be – and unfortunately so, whatever the Fed will be doing in terms of setting interest rates and dealing with the bonds it has purchased against issuing new fiat dollars.

While this is certainly a gloomy message, it might help investors to make wise decisions. Because if the Fed causes another round of trouble, it will most likely resort to even lower interest rates and issuing even more fiat money. So whatever happens short-term, there is good reason to expect that the fiat dollar — and this holds true for all fiat currencies — will lose value.

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The Part-Time Critics of Central Banks

07/14/2017Mark Spitznagel

There seems to be no shortage today of investors and pundits criticizing the market interventions of the world’s central banks. Monetary stimulus in the form of artificially low interest rates and bloated central bank balance sheets ($18.5 trillion, to be exact), the argument goes, have created another dangerous financial bubble (evidenced by ubiquitously bubbly stock market valuation ratios) that ultimately threatens the financial system yet again. The author shares wholeheartedly in this criticism.

The ethical problem is, where were these voices when this all started, with Greenspan in the 1990s and, more specifically, with Bernanke in 2008? The central bank critics today who were not critics of — and in most cases were even sympathetic to — the great bailouts and stimulus that started almost a decade ago have reserved their criticisms only for those interventions that appear to hurt their interests, as opposed to those that have helped them. After all, no one would disagree that bailouts and monetary stimulus got us out of the last financial crisis, but they also certainly got us to where we are today, vulnerable to another even bigger one.

We are so concerned about our friend the strung-out junkie, though we paid little mind when they were but a casual user. It is so easy to care when problems become obvious and critical, so hard when they are subtler and nascent. Artificial stimulus in an economy is the same: it is easily ignored as a problem in its infancy, but it always develops into a huge problem. Economies and markets are structurally altered and distorted by such stimulus, such that it cannot be removed without breaking those new structures. It must rather be ever increased, though even this will only delay an inevitable collapse.

It is just too easy in today’s investing environment, and even necessary for most participants, to sympathize with and even exploit central bank interventions. Doing otherwise creates an opportunity cost in one’s career and investments. But doing so puts one in the position of enabler to the economic system’s self-destructive dependence on artificial stimulus. One cannot be a part-time classical liberal, criticizing central planning only when it runs contrary to one’s interests. Indeed, this is the very problem of Socialism: there are winners and losers; the winners are in the here and now — the seen; the losers are in the future — the unseen. The winners don't complain, and the losers can‘t until it is too late.

But as the future becomes the here and now, the unseen becomes the seen, those who now think they are anticipating a problem and its cause, yet supported that same cause when they stood to benefit, must be seen for what they are: fellow travelers in the central planning ideology that grips today’s financial markets. They are too late.

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Today Janet Yellen Explained (Yet Again) Why Interest Rates Should Stay Low

07/12/2017Ryan McMaken

On Tuesday, Fed Governor Lael Brainard downplayed past talk of numerous rate hikes from the federal reserve and suggested that he Fed may "not have much more" to do in terms of rate hikes. "In light of recent policy moves, I consider normalization of the federal funds rate to be well under way," Brainard said.

Today, speaking before Congress, Janet Yellen built upon Brainard's earlier comments, but simultaneously suggested that there will be "gradual rate hikes" over "the next few years,"  and hinting that many more rate hikes won't be necessary because "the neutral rate is low by historical standards."

Markets took this to mean — probably correctly — that the Fed is moving in a more dovish direction. 


The "Neutral Rate" Canard 

Note that both announcements are based on the idea that the "neutral rate" is unusually low, so while a target rate of 1.5 percent may seem quite low by historical standards, it's not really low. It is near the neutral rate — also known as the "natural rate."

In other words, the "natural rate" has fallen below where it was in the past, so now, the interest rates we saw in the days of yore — those around 3 per cent or 5 percent — would today be much too high. 

Bloomberg explained a bit more of the Fed's logic here last year: 

When Fed Chair Janet Yellen wants to explain why the Fed is keeping rates so low, she cites the natural rate. At the press conference following the FOMC’s June meeting, she said the neutral interest rate—which is essentially synonymous with the natural rate—“is quite depressed by historical standards.” She added: “I think all of us are involved in a process of constantly reevaluating where is that neutral rate going.”

Politically speaking, identifying this "natural rate" as being very low allows the Fed to create the perception that its very-low target rates aren't really all that stimulative at all. They're practically neutral! Just look at the natural rate, they'll tell us. 

The problem however, is that all good economic theory tells us that the Fed has no idea what the natural rate actually is. Earlier this year, Mark Spitznagel explained:

How do we even know what that neutral rate is? The neutral rate is, by its current definition, inherently unobservable, as there is no discovery process in short-term interest rates (and there hasn’t been for as long as any of us have been around). Central banks calculate the neutral rate based on their formulas and identifying assumptions about output gaps and what interest rates, according to those models, will close those gaps. Here we have an immense circularity problem: Policymakers think they know the neutral rate because the assumptions of their interventionist model that they impose on the data say so, not because they have any insight that the market would actually clear at that rate, sans intervention. There is an underlying assumption that “markets, left on their own, are wrong, while our model is right.” Moreover, they are using observable data as model inputs that are the result of interventions that are already in effect. There are no controlled experiments in economics. Only market participants, acting freely in borrowing and lending at whatever interest rates make sense for that borrowing and lending, can ever discover what the neutral rate should be.

Joseph Salerno explains this in even further detail in his article "The Fed and Bernanke Are Wrong About the Natural Interest Rate."

All this talk about the natural/neutral interest rate thus provides political cover for the Fed, and allows the FOMC to claim that they're using economic science in determining the "correct" target rate. In truth, the Fed has no idea what the natural rate is but is really just proceeding with great caution because the Fed's leadership knows that allowing interest rates to increase beyond the current low levels would upset the fragile economy. 

The Fed's Balance Sheet 

Thus, the question of the target rate remains constantly in flux, just as the Fed would like to have it. 

Equally amorphous is the question of reducing the Fed's balance sheet. This reduction, according to both Brainard and Yellen, will come "soon" (whatever that means). One thing we  know for sure: it will take a while to implement

Ms. Yellen told the House Financial Services Committee that unwinding a $4.5 trillion-plus balance sheet that includes $2.5 trillion in Treasuries and the rest in mortgage-backed securities will probably take until 2022 before it shrinks to pre-crisis levels. Fed officials have not decided yet on longer-term policy framework that will affect the size of reserves, she said.

This assumes, of course, there is no worsening in the economy between now and 2022, which is a tall order, to say the least. 

Moreover, what are the details of how this balance-sheet wind-down will occur? It's a great mystery. Also mysterious is why, in an age of massive home price inflation, the Fed still isn't unloading those mortgage-backed securities. 

All in all, there's extremely little to see here in Yellen's testimony. It's the usual routine: the economy is experiencing "moderate" growth. We'll raise rates — but not too much! We'll wind down the balance sheet "soon."

Meanwhile, the Fed continues to invent new explanations of why it needs to remain accommodative. The totally arbitrary 2-percent inflation target continues to serve as a justification for continued low rates. And, more recently, the "natural rate" explanation is starting to serve as a convenient excuse as well. 

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The Super Bubble Is in Trouble

You do not need to be a financial market wizard to see that especially bond markets have reached bubble territory: bond prices have become artificially inflated by central banks' unprecedented monetary policies. For instance, the price-earnings-ratio for the US 10-year Treasury yield stands around 44, while the equivalent for the euro zone trades at 85. In other words, the investor has to wait 44 years (and 85 years, respectively) to recover the bonds' purchasing price through coupon payments.

Meanwhile, however, the US Federal Reserve (Fed) keeps bringing up its borrowing rate; and even the European Central Bank (ECB) is now toying with the idea of putting an end to its expansionary policy sooner rather or later. Most notably, however, US long-term rates have come down since the end of 2016, despite the Fed raising its short-term interest rate. How come?


Presumably, investors seem to expect that the Fed might not hike interest rates much further, and/or that higher short-term interest rates will prove to be short-lived, to be reversed quite quickly. In any case, bond markets do not seem to expect interest rates to go back to normal levels — that is toward pre-crisis levels — anytime soon. Several reasons could be responsible for such an expectation.


First and foremost, the US economy appears to be addicted to cheap money. The latest economic recovery has been orchestrated, in particular, through a hefty dose of easy monetary policy. It is therefore fair to assume that market agents will have a hard time coping with higher interest rates. For instance, corporations, consumers, and mortgage borrowers, in general, will face higher credit costs and a less favorable access to funding if and when interest rates edge higher.

In particular, higher interest rates could send the inflated prices of stocks, bonds, and housing southward. For instance, expected future cash flows would be discounted at a higher interest rate, deflating their present values and thus market prices. The deflation of asset markets would hit borrowers hard: Their asset values would nosedive, while nominal debt would remain unchanged so that equity capital is wiped out — a scenario most investors might assume to be undesirable from the viewpoint of central banks.

Moreover, the yield curve has become flatter and flatter in recent years. This, in turn, suggests that banks' profit opportunities from lending have been shrinking, potentially dampening the inflow of new credit into the economic system. A further decline of the yield spread could bring real trouble: In the past, a flat or even inverted yield curve has been accompanied by a significant economic downturn or even a stock market crash.

That said, investors might expect that central banks find it hard to bring interest rates back up, especially back to a level where real interest rates are positive. This holds true for the Fed as well as for all other central banks, including the ECB. This is because the monetary policy of increasing borrowing rates by a significant margin would most likely prick the “Super-Bubble” which has been inflated and nurtured by central banks’ monetary policies over the last decades.

However, it wouldn’t be surprising if, again, central banks, the monopolist producers of fiat money, turn out to be the major course of trouble. After many years of exceptionally low interest rates, central banks may well underestimate the disruptive consequences an increase in borrowing rates has on growth, employment, and the entire fiat money system. In any case, the artificial boom created by central banks must at some point turn into bust, as the Austrian business cycle theory informs us.

The boom turns into bust either by central banks taking away the punchbowl of low interest rates and generous liquidity generation; or the commercial banks, in view of financially overstretched borrowers, stop extending credit; or ever greater quantities of fiat money need be issued by central banks to keep the boom going, inflating prices so that ultimately people start fleeing out of cash. In such an extreme case, the demand for money collapses, and then a Super-Super-Bubble pops.


In this context, it is interesting to see that the price of Bitcoin has been skyrocketing in recent years. There are certainly several reasons for this. One reason is undoubtedly the fact that the cyber unit offers a potential “escape route” from fiat money. Bitcoin (and other cyber units as well) might well be seen, and increasingly so, as a “safe haven” in future times of trouble. And there will be for sure new waves of trouble going forward — whether central banks will tighten interest rates or not.

As alternatives to fiat money become increasingly accepted, positive spill-over effects can be expected for gold. Gold has always been the monetary prototype of a “safe haven.” It may be increasingly in demand for its store of value function going forward and, by making use of the blockchain, even as a digitalized means of payment representing a claim on physical gold. Once the Super-Bubble pops, we will see for sure what people demand as the ultimate means of payment: gold or cyber units, or both.

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This Week's Fed Events

06/26/2017C.Jay Engel

Here are this week's events relating to the Fed. All times Eastern.

Monday, June 26

  • Chicago Fed National Activity Index. 8:30am
  • Dallas Fed Manufacturing Survey. 10:30am

​Tuesday, June 27 

  • San Francisco Fed President John Willaims will speak at The Economic Association of Australia on "The Global Growth Slump: Causes and Consequences" in Sydney, New South Wales. 4:00am
  • Richmond Fed Manufacturing Index. 10:00am
  • Philadelphia Fed Reserve President Patrick Harker will speak on the economic outlook and international trade at the European Economics & Financial Centre. 11:15am
  • Fed Reserve Chair Janet Yellen will discuss global economic issues at the Conversation between Chair Yellen and Lord (Nicholas) Stern, President of the British Academy in London. 1:00pm
  • Minneapolis Fed Reserve President Neel Kashkari to participate in a townhall in Houghton, Michigan. 5:30pm

Wednesday, June 28

  • San Francisco Fed President John Williams will speak on The Global Growth Slump: Causes and Consequences at the The Economic Association of Australia, Eminent Speaker Series 2017 in Canberra, ACT. 3:30am

Thursday, June 29

  • The third estimate for first-quarter GDP. 8:30am
  • St. Louis Federal Reserve Bank president James Bullard to deliver a presentation on the U.S. economy and monetary policy at the Official Monetary and Financial Institutions Forum (OMFIF) City Lecture in London. 1:00pm

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The ECB Blames Inflation on Everything but Itself

06/23/2017Louis Rouanet

Unsurprisingly, central banks are reluctant to claim credit for inflation. In their latest bulletin, the European Central Bank (ECB) published the graph below explaining what causes inflation.

See the problem? Neither the money supply nor the ECB are mentioned. While there are many factors that influence the purchasing power of money, inflation is still inherently a monetary phenomenon and the role central banks play simply can’t be ignored.


Instead, the ECB prefers to do what all central banks did just before the 2009 great recession: blame inflation on rising food and energy prices. But large central banks like the ECB have a strong and disproportionate effect on energy prices, as predicted by Austrian business cycle theory. The rise in oil prices in 2007, for example, was triggered by the end of the euphoric monetary boom initiated by the Fed and the ECB in the years prior. As investment in energy production was fueled, in part, by credit expansion instead of real savings. The quantity of producer’s goods — or at least of some of them — revealed themselves to be insufficient to complete the plans of entrepreneurs, thus generating a sharp increase in their prices.

Therefore the ECB has some responsibility in the so-called external drivers of inflation.

Another problem worth noting is that the ECB seems eager to revive the old myth of cost push inflation. The author of the ECB bulletin writes that: "Domestic price pressures result mainly from wage and price-setting behaviour, which is closely linked to the domestic business cycle."

But it is the values of the first order goods which are imputed back to productive factors, rather than the other way around. As Henry Hazlitt puts it:

The other rival theory is that inflation and the rise of prices are caused by higher wage demands — by a “cost push.” But this theory reverses cause and effect. “Costs” are prices. An increase in wages above marginal productivity, if it were not preceded, accompanied, or quickly followed by an increase in the supply of money, would not cause inflation; it would merely cause unemployment. It is not true, as so often assumed, that a wage increase in a given firm or industry can be simply “added on to the price.” Without an increased money supply, prices cannot be raised without reducing demand and sales, and hence production and employment. We can stop the “cost push” if we halt the increase in the money supply and repeal the labor laws that confer irresponsible private powers on union leaders.

With a constant demand for money, it is possible for some prices to go up but it is impossible for all prices to go up. For all prices to go up, a central bank must exist and pump more money into the economy. If, in a free market, the cost for oil increases because of an increase in demand, whether foreign or domestic, other prices, ceteris paribus, must fall.

Of course, the ECB is right to argue that global commodity prices affect the domestic price level. Nonetheless, the bulletin deliberately understates the impact the ECB has on the movement of prices. To simply chalk it up to international pressure will, for sure, become a handy justification for the ECB if they fail to maintain inflation under 2%.

But don’t be fooled, central banks, not oil, are responsible for the debasement of the currency.


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