[X3pilot]

OK, I'm fairly ignorant on market/finance issues but I'm having trouble digesting the latest news.

The Fed decides to buy US Bonds (debt) as a measure to put money into the system to bolster the economy. Yet this drives value of dollar down against other currency worldwide, driving up prices of other things like commodities. (biggest issue for me is increase in oil/gasoline prices despite no supply/demand signals) which makes it harder on the day to day consumer, who spends less or loses a job, which hurts the economy.

So in my mind, it makes no sense as to how the Fed is "helping" the economy.

Very tempting to start rolling that tin foil hat...could this actually be manipulated? I almost got convinced once that the secret Cheney "energy policy summit" in 2000 created the idiotic market for oil that we have now, but really want to think it's just the natural fall out of some sketchy market regulation.

Or maybe I shouldn't think about these things...

 

[ire]

I agree with you that it doesn't make sense. There is record amounts of money out there, but the corporations aren't spending it. We don't need more money, we just need those who have it to spend it.

 

[MMike]

Vote for the Magic Bean-based economy!!

 

[Pesqueeb]

Long story short: This is an attempt to drive interest rates even further down in the belief that practically free money to the consumer will drive buying and convince businesses to hire.

Personally, I'm still not sure how this works on a purely mechanical level. Banks already borrow at or near zero percent from the fed. Hence why I have a 30 year mortgage loan @ 4.3% Interest rates for you and I to borrow have already dropped as much as I think the banks themselves are willing to loan at. How all of this potentially inflationary cash being created out of thin air is going to convince any bank to loan at even lower rates is confusing to me.

*edit 2: http://www.npr.org/blogs/money/2010/11/03/131043062/federal-reserve

*edit
cue the Desmondo/3d/renegaderick talk about the Fed/one world government/9-11/all seeing eye in 3...2...1...

 

[dante]

Whoa. I'll give it my best shot, but this could be a question that deserves several books worth of information to actually convey properly...

Inflation vs Deflation

Ok, I've linked to this article before, but I think that it bears repeating. The Fed is *deathly* afraid of deflation, which is a contraction in the supply (or velocity) of money. Just think about the housing bubble, and bursting. You buy a home in 2000 for $100,000, and 5 years later you sell it for $300,000. About $200,000 just appeared out of thin air. Wealth was just created without any work, without requiring an offset of productivity growth or trade balances, it just went *poof* and there it was. This increased the money supply, and if you, the prior homeowner has that $200,000 in hand you're more likely to spend it and get it out into the system. So if you spend that $100 at a restaurant that you might not have gone to, the restaurant owner is more likely to buy a bike from your shop (velocity of money). Note, you don't have to sell your house in order to get this, you could just as easily refinance, take out a HELOC, or even be more free with your cash since you're counting this massive investment that you think have in your overall portfolio. Also, keep in mind that velocity of money is FAR FAR FAR more important than how much cash is out there. Just imagine that you have $100k in cash in a safe in your house, and you don't touch it, you don't spend it, you just leave it there all year. It's impact on the economy is exactly zero. However, if you buy $100k worth of widgets from someone and turn around and sell them, and you do it 6 times that year, your impact is $600k as opposed to zero.

What the Fed does in this situation is try to keep a handle on the economy, and keep it from getting too hot. $100k homes shouldn't be worth 3x (5x? 7x?) as much in 5 years, because then people can't afford to buy them. They do this by controlling interest rates. If you're looking at only spending $1,000/month on a mortgage, if rates are 7% you can only afford a $150k mortgage. If rates are 4%, you can afford a $210,000 mortgage. When rates go up, people can afford to pay less, therefore they borrow less, and prices come down (and there is less money in the system). When rates fall, people can afford to pay more, therefore prices go up (and there is more money in the system).

So think about how this works with businesses. Almost all businesses run on credit. Company A borrows $100,000 from a bank to bring in bicycles from China on a 6 month loan. It takes 1 month to bring the bicycles into the country, and then Company A turns to Bicycle Shop B and sells them bicycles on 3 month terms. After 2 months Bicycle Shop B sells a bike to Consumer C, and the the Bicycle Shop is able to turn around and pay back it's loan to Company A, who can pay back it's loan from the bank. When credit is loose, Bike Company A can afford to bring in a lot of bikes, and offer great credit terms to the bike shop, and maybe even to the customer... Unemployed people don't buy as much, and unemployed people who's unemployment insurance has run out don't buy *anything*.

So what happened?

Well, the housing bubble burst, banks either went bankrupt or were functionally bankrupt, credit dried up, and suddenly we are looking at the possible contraction in the money supply (deflation). As per the minyanville article I posted before, even though there was a large *supply* of money out there, banks weren't lending and even more so, people weren't borrowing. Banks are trying to rebuild their balance sheets, which is why they're borrowing from the fed at 0% and charging you 13% (or 30%) for your credit card. People aren't borrowing because they don't want to incur more debt, even if it's only at 4.25% like most mortgages are right now. Why buy a house if the value's going to drop even further? That's what's called a deflationary spiral, where people avoid spending money because the value of whatever you're buying is likely to drop in the future. People don't spend money, prices drop, people think they're going to drop further so they don't spend money, prices drop further, and it goes on and on. This is what happened during the Great Depression.

For companies, the Credit Crunch was catastrophic. Imagine the scenario above. Where previously Company A had been able to get a nice low rate of 4% for 6 months from their favorite lender CIT, suddenly CIT went bankrupt. New banks weren't willing to lend, or at least not on anywhere near favorable terms. Maybe they only offered 4 months on the loan, and charged 7%. Or 10%. Without the availability of credit, Company A can only bring in half as many bikes, and has to lay off 30% of its workforce. Or maybe they go out of business and have to lay everyone off. What they did was predict that credit was going to be tight, not only for them but also for their customers. Their customers had bought bikes with their HELOCs, or used credit cards to pay for them, or used HELOCs to pay off their credit cards. So suddenly the cost of business is skyrocketing, and sales predictions are pretty low.... so they lay off 30% of people in anticipation of tough times ahead. Maybe when sales pick up and credit becomes available they might hire more people, but in an effort to preserve capital they got rid of their most costly component, employees.

The Fed

As noted, The Fed has tools at which to fight inflation or deflation, the primary one being control over interest rates that it charges banks for money. The Fed Funds rate was ~5% back in 2007 before the bubble burst. As the housing bubble burst, and credit dried up, the Fed drove rates down in a desperate effort to provide credit liquidity to the marketplace. Over a year and a half, the Fed dropped the rate at which banks borrow from them from 5% down to 0%. Only problem is that didn't work, or at least not to the level that would be acceptable. The economy was still shedding jobs, people and companies weren't borrowing, and banks weren't lending. The Fed needed a way to decrease the costs associated with borrowing money, and since it can't drop the Fed Funds rate below zero...

Quantitative Easing

I think Wikipedia actually says it quite succinctly:

Quantitative easing is another way to influence monetary policy, only recently begun to be used in the United States. Other countries, such as Japan, have provided a template for some Fed actions. Essentially, quantitative easing provides a method for the central bank to provide funds at lower than zero interest rates, in order to increase the monetary supply and combat deflationary forces. This is accomplished by the Fed purchasing U.S. government debt with newly printed U.S. currency. In essence, the Fed is monetizing the debt. In the current (late 2007 to today) macro-economic environment, the slowing velocity of money has induced U.S. central bankers to pursue a variety of new, and to some radical, policies to produce economic stimulus.

So, imagine the 10 year US Treasury (on which a lot of mortgage rates are based). In October of 2008 (when the Fed Funds rate originally went to zero), the amount paid in interest was ~4%. So a super-stable, guaranteed rate of return was 4%. Before investors take more risk, they need a better return on top of that. Mortgage borrowers are inherently more risky than treasuries, so at that time investors demanded ~2% on top of that 4%, meaning mortgage rates were 6%. Commercial lending was probably anywhere from 5% - 12%. The only way that the US government could lower that 10y Treasury yield (since they're traded on the open market) would be to artificially raise the price, which lowers the yield. If you have to pay more for it, the effective yield goes down. For QE, the Fed steps in and buys US Treasuries, making them more expensive to buy, which in turn lowers their effective yield. The only way the Fed can get money to buy those treasuries is to basically create it out of thin air. This pushes down interest rates, and gets more US currency into the system (Bernanke's "printing press").

So now the effective rate on 10 year US Treasuries is 2.36%, and sure enough, mortgage rates are hovering around 4.25%. I would imagine that commercial lending rates are probably pushed down as well. The Fed is panicking that unemployment is still 9.5%+, GDP growth is anemic, and they are DEFINITELY concerned about deflation. As such, they are trying to pump as much liquidity and cash into the market as possible, so that people will start buying, companies will start creating, and then hiring more people. Inflation they can handle, as they can raise interest rates as high as they need to to fight it. Deflation is a much harder problem, since they can't lower rates below zero. So when the Fed errs, it's going to err on the side of pumping money into the system as opposed to risking a deflationary spiral.

All *actual* data currently shows very little inflation. We're chugging along at around or below 2%, which is less than the Fed's target of ~3%. Raw materials are flat, or down. There's not the demand to cause prices to rise. That gallon of gas might be $2.90, but it's down from $4.50 2 years ago. My supermarket has brightly colored yellow signs that signify price cuts, and there are only about 400,000,000 of them throughout the store. (both of those are bad examples, actual inflation data omits food and energy)

The main question is, if there's no inflation now, what will happen in another 5-7 years? The market says no inflation, or rather ~2.36% over the next 10 years. For all of the Fed's quantitative easing, there are still far more people/countries/funds buying US Treasuries based on the fact that they believe the current rate is still a good one. Fearmongers like Glenn Beck are trying to say that MASSIVE HYPER ZIMBABWE STYLE INFLATION IS RIGHT AROUND THE CORNER!!! (side note, I heard him say yesterday that inflation and deflation were the exact same thing. In the same sentence. I'm permanently dumber for the 3min that I listened to him.) The truth? Nobody knows for sure what's going to happen. Some people will be right and make a ton of money, some will be horribly wrong and lose a ton of money, and the best we can hope for is that people far smarter and more educated than you and I are at the helm.

Whew. Sorry for that getting so long-winded, and remember I"M NOT AN ECONOMIST!! I'm just doing the best I can...

 

[X3pilot]

Wow!! Thanks so much for taking the time to type that. It makes more sense on a technical level now. Guess I should be happy they're doing something instead of waiting till it goes terribly bad one way or the other.

 

[Pesqueeb]

stuff

I owe you a beer.

 

[dante]

No worries, just trying to shed some light onto a subject that I barely understand...

And I'm glad I'm not the only one who caught Glenn Beck's little "misunderstanding", lol.

 

[jimmydean]

Dante, if nothing else, you counteract the effect Glenn Beck has on at least a few of us good souls. Thanks.

 

[dante]

Now if I can only figure out how to condense that massive post down into 4 words, like the opposite of "ZIMBABWE INFLATION BUY GOLD!!!" maybe I can get a show on Fox...

 

[ohio]

Here's what makes no sense: there's no shortage of cash or capacity, interest rates are already zero and even banks and businesses aren't borrowing (they already have excess capacity, why would they build more). Introducing money doesn't seem to stimulate anything but inflation. It seems to me the Fed is trying to solve a commerce/confidence problem they don't have any control over with the only tool they have on hand... they're pushing a rope. And all they're doing is further devaluing a dollar that is honestly on the brink of collapse. We're nowhere NEAR deflation. The way we now calculate CPI obscures that, but it's really a non-issue.

 

[stoney]

what do you mean... CPI should include cars and tv's, but not food or gas? that makes no sense

 

[jasride]

stuff....

I learn from the monkey

 

[J-Dubs]

The banks, venture capitalists and much of Wall St are waiting to get their money back from the DOW collapse.
Once we see the numbers looking like what they were before the big drop, then we'll see them lending money again.

[/tinfoil]

 

[dante]

what do you mean... CPI should include cars and tv's, but not food or gas? that makes no sense

True, but if you include food and energy into the CPI, then we had 100% inflation between 2007 and 2008 (OMG, RUN FOR THE HILLS!!! ) and 50% deflation between 2008 and 2009 (OMG, RUN FOR THE HILLS!!! ).

I mean, do you really want to base your assumption of inflation on this?

If so, we're fvcked, enjoy having your boss give you a 50% reduction in pay just because oil futures went from $70 down to $35.

edit: I'm not saying the CPI is perfect, but to claim that it's 100% wrong is FAR to big of a stretch for me to agree with.

 

[ohio]

edit: I'm not saying the CPI is perfect, but to claim that it's 100% wrong is FAR to big of a stretch for me to agree with.

The problem for me is more that relative comparisons are being used seemingly without any correction between Fed and BLS calculations, or retroactive correction factor for changes in methodologies.

Also, your energy curve is helpful but obviously would be weighted relative to household spend. I'm not asking to pin CPI directly to energy, just include costs of energy and food when trying to figure out how much purchasing power a household has. While we're at it, we need to re-evaluate indices more than every 10 years, seeing as mobile phones and internet have probably had some small effect on purchasing power as well.

 

[Silver]

What they should do is send everyone a check for 10k. If they did that the spooks and the beaners would get money, so instead we give it to the banks.

Who don't lend it...so we give them more. Makes sense to me.

 

[ALEXIS_DH]

cough, hyper-inflation around the corner, cough.....

 

[skatetokil]

cough, hyper-inflation around the corner, cough.....

Well, this is sort of how hyperinflation happens...

There are two operating theories here that you need to understand that Dante touched on, but if you want to find further reading, I'll at least throw out some key words.

One is "balance of payments theory," which has to do with the idea that imports = exports + foreign debt. Basically we have been exporting very little, importing a great deal, and running up huge foreign debt for the last 15-20 years. One way to deal with the imbalance is quantitative easing, which is the printing of new money to drive down the real value of the dollar (and its exchange rate with respect to important trading partners) and take government debt out of circulation. In practice, this operates as a tax on holding dollar denominated savings, which makes it a very dangerous game and brings us to the next important issue.

The "overshoot theory," attempts to explain volatility in exchange rates and prices. Basically, what the theory says is that financial asset prices respond to money supply increases much more quickly than prices for consumer goods, wages etc. So we're seeing a run up in the stock market and some commodities but no real inflation in the consumer economy. However, the theory indicates that at some point we will reach a magic threshold where asset prices will "unstick" and move to the new equilibrium level created by the monetary policy.

There is no way to really predict the timing or magnitude of the shift because if the adjustment happens to coincide with a loss of confidence in the US Government and its ability meet its obligations (because our debt holders perceive us to be printing money), there could be a run on the dollar and a massive increase in consumer and asset prices in a very short period of time. This is a hyperinflation.

The Fed's stated policy is to "soak up liquidity" during an adjustment of this kind, but it's only real tool is to manipulate the interest rate on US Government debt and or issue more of it, and if nobody is buying that toxic waste, it ceases to be an effective tool.