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Friday, March 29, 2024

The Fed's Voodoo Economics

Courtesy of Econophile

From The Daily Capitalist

In its latest outlook, the Fed said:

“Even though the recovery appeared to be continuing and was expected to strengthen gradually over time, most members projected that economic slack would continue to be quite elevated for some time,” according to the report, which doesn’t identify the specific governors or regional-bank presidents making comments.

Officials expected inflation to remain “below rates that would be consistent in the longer run with the Federal Reserve’s dual objectives” of maximum employment and stable prices, the minutes said.

They believe that as long as there is excess industrial capacity, we won’t have inflation.

The hot topic running through the halls of the Fed is: When should it dump the $1.1 trillion of mortgage related debt and securities it bought? In a program which tried to suck bad assets out of the banks to create liquidity in the system, the Fed went on a buying spree of these assets which ended in April of this year.

The data reveals that their policy has been a failure because bank credit and money supply are still declining. The result of their policy was to inject the trillion dollars in the pockets of the big banking houses who were more than pleased to dump these “toxic” assets as they were then called.

When they start to sell these assets it will be an attempt to “drain the pond” of the same trillion dollars they put into these banks. Theoretically this could lead to a tightening of the money supply which they view as being too high. The fear is that if they do it too soon, they may raise interest rates, increase the liquidity squeeze, and put a brake on economic recovery. If they do it too late they fear inflation. What’s a central bank to do with such a dilemma?

What is interesting is the Fed’s lack of understanding of the dynamics of inflation. They take the mostly Keynesian view that because we have idle industrial capacity, the risk of creating inflation right now is very low. In other words, injections of cash into the economy will not have an inflationary impact on prices because, until we are at near full industrial capacity, prices won’t rise.

This concept is wrong.

The Fed and the many analysts who talk about inflation confuse the concept of inflation with supply and demand for goods. What they should be looking at is the supply and demand for money and credit.

As an example, it is often thought that high oil prices have an inflationary impact on the economy. The thinking goes that since oil is a factor in the production of about everything, a rise in oil prices will cause a rise in the price of everything. But that never occurs. Assuming that the supply of money in a system is fixed, if I have to spend more money on gasoline it means that I have less money to spend on something else. So while certain prices may go up, the fact that I am spending less on other goods means that there will be less demand for those goods and their prices will fall. These are factors related to the supply and demand for goods.

We have to go back to the general definition of inflation: a situation where all prices increase, not just some. The only way to do that is to increase the money supply. If you had $1,000 and all of a sudden you and everyone else looked in your pocket and saw that you had $2,000, it is certain that all prices would be bid up by this money supply increase. No real wealth was created, we just had more pieces of paper chasing roughly the same amount of goods.

How this really works is that when the Fed increases the money supply (it has a variety of ways to do this), the first to get the new money are prime borrowers of banks and they use the new money to buy the goods they want, increasing demand and prices for these goods. By the time the money has worked its way through the economy, the last guy in line finds that all prices have gone up. It’s the lucky guy first in line who benefits the most because he bought goods before prices went up.

So, going back to the excess capacity idea, just because you have low industrial production capacity doesn’t mean you can’t have inflation. Again the supply and demand for goods (capacity) has nothing to do with inflation (money).

The recession of 1974 is a good example of this. Then we had stagflation: high inflation and low economic activity. This isn’t supposed to happen. Here are the charts:



Yet the Fed persists with their faulty theory.

It is difficult to predict the outcome of their sale of these toxic assets. It may or may not cause interest rates to rise depending on what the international situation is with other currencies. If the EU continues to have problems, then the dollar will remain as the world’s reserve currency and interest rates will remain subdued as cash stays here. In this situation, the result of mopping up a trillion dollars from the economy will not be significant.

If the international situation is resolved and currencies stabilize at whatever level they achieve, then the sale may increase interest rates. This would be a positive factor. Right now credit is very tight and money supply is low because mostly regional banks are afraid to lend because of all the bad debt on their balance sheets. We need deleveraging to make the economy grow again. The short-term result would be negative, but it would free up the balance sheets of regional banks (as the CRE assets they hold as collateral go under, they would go broke or recapitalize), and this cleansing effect would set the stage for real organic economic growth as liquidity would then improve as surviving banks would be eager to lend.

I don’t have a crystal ball here because there are too many variables to make a call. I have my doubts that the Fed can sop up all the excess reserves now held by banks. If that is the case, when banks recover, rising bank liquidity and credit would lead to significant inflation.

Please stay tuned.

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