Leithner Letter Nos. 159-162
26 February 2013 - 26 June 2013

Four years ago this month the Federal Reserve began its epic program of monetary easing to rescue an economy in recession. On Wednesday, Chairman Ben Bernanke declared that this has worked so well that the Fed must keep easing money for as long as anyone can predict in order to save a still-sputtering recovery. That’s the contradiction at the heart of the Fed’s latest foray into “unconventional policy,” which is a euphemism for finding new ways to print money: the economy needs more monetary stimulus because it is still too weak despite four years of previous and historic amounts of monetary stimulus.

… The Fed committed Wednesday to purchase an additional $45 billion in long-term Treasury securities each month well into 2013, in addition to the $40 billion in mortgage assets it is already buying each month. At $85 billion a month, the Fed's balance sheet will thus keep growing from its current $2.9 trillion, heading toward $4 trillion by the end of the year. Four years ago it was less than $1 trillion. … Meantime, the Fed’s near-zero interest rate policy will continue to disguise the real cost of government borrowing. One reason the Obama Administration can keep running trillion-dollar deficits is because it can borrow the money at bargain rates. Stanford economist and Journal contributor John Taylor says the Fed has bought more than 70% of new Treasury debt issuance this year.

All of this will create a fiscal cliff of its own when interest rates start to rise. The Congressional Budget Office says that every 100 basis-point increase in interest rates adds about $100 billion a year to government borrowing costs. Pity the President and Congress who have to refinance $15 trillion in debt at 6%. If Mr Bernanke really wants to drive the President and Congress to reduce future spending, he shouldn’t keep bailing them out with easier money. The overarching illusion is that ever-easier monetary policy can return the U.S. economy to a durable expansion and broad-based prosperity. The bill for unbridled government spending stimulus is already coming due. Sooner or later the bill for open-ended monetary stimulus will arrive too.

The Fed’s Contradiction
The Wall Street Journal (12 December 2012)

The great reflation by the world’s central banks has lifted more than just markets. Chief executives, bankers and politicians in Davos for the World Economic Forum last week were getting bullish, particularly on the U.S. economy, for the first time in more than four years. But by keeping interest rates ultra low, central banks including the Federal Reserve may have created a ticking time-bomb for investors in the bond market.

Low rates have been a bonanza for many. Bond investors have earned bumper profits, while companies, homeowners and governments have refinanced debt at bargain rates. But extreme central-bank actions have triggered a search for yield, with worrying echoes of the pre-crisis boom when investors made bets that later backfired. … Right now, the bond market doesn’t appear at risk of a major selloff that could cause those losses. … But markets can shift suddenly if sentiment changes. Should investors become convinced that a sustainable economic recovery is under way, or lose confidence in central banks’ ability to contain inflation, then yields are likely to move sharply higher. That would inflict even more pain than in the past.

… When losses come, they can build quickly. Just ask the Bank of England, the biggest holder of U.K. government bonds thanks to its quantitative-easing program, under which it has bought £375 billion ($593 billion) worth. In the first 10 days of January, it saw mark-to-market losses of £7 billion as yields rose, Bank of America-Merrill Lynch estimates, wiping out a good chunk of the paper profit the BoE had made. There are reasons to believe that central banks will seek to prevent market yields from rising. After all, tighter credit could choke off any recovery. But by deferring problems, artificially low yields are a double-edged sword – generating savings for borrowers now but storing up losses for lenders in the future. The time bomb is ticking.

Yielding to Bonds’ Dark Side
The Wall Street Journal (27 January 2013)

Of Artificial Profits and Inflated Stock Markets

Are high and rising profits, together with the expectation of more to come, an obviously and unquestionably good thing? Not according to The Huffington Post (Corporate Profits Soar To Record, Now More Than Double Their Peak Under Ronald Reagan, 17 January 2013). “Give yourself a hand, Corporate America,” it snarls, “you have managed to post record profits despite the country being run by a socialist, fascist Muslin [that’s really how they spelt it] dictator for the past four years [italics added].” HuffPost continued in this sarcastic (and largely accurate) vein: “No other president since World War II, when America was also run by socialist monsters, has seen such a profit increase.” Figure 1 (which, like Figures 3-6, plots data compiled by the Federal Reserve Bank of St Louis) shows that, when expressed as a percentage of GDP, in 2010 after-tax corporate profits returned to the peak they reached in 2007-2008. Late in 2012, they rose further and to their highest level since at least 1947 (when record-keeping began). Profits presently exceed 10% of America’s GDP. From more than 8% of the economy (as conventionally measured) during the late-1940s, for the next 35 years this percentage fell erratically and cumulatively drastically; by the mid-1980s, it had fallen by more than half to ca. 3% of GDP. Since then, apart from the plunge and equally sharp rebound in 2008-2010, profits have risen almost without interruption and more than trebled.

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Chris Leithner


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