Why the Fed's Out of Control

Oct. 29 (Bloomberg) -- The Federal Reserve cut its benchmark interest rate by half a percentage point to 1 percent, matching a half-century low, in an effort to avert the worst U.S. economic downturn in the postwar era.

The U.S. government and Federal Reserve continue to give us signs as to where they stand, where we're going, and how we’re going to get there. Cutting the Fed Funds Rate to 1%, is just one more step towards zero, or next to zero interest rates.

Big Cut, Big Deal, or Big Woop?

This was not a big surprise, and the only question coming into Friday's trading day was whether or not it would be a 50 BP or 75 BP cut. In actuality, the cut wasn't significant at all.

You see, the Fed Funds Rate is a TARGET rate set by the Federal Reserve. The actual rate is derived by trading between banks. This rate usually fluctuates around the actual rate. In recent weeks, this hasn't been the case. In fact, the actual rate has been trading below 1% for some time.

If you're wondering how this is possible, it's really pretty simple. The banks want to either be lenders or borrowers. By allowing this process to run uninfluenced would mean short term interest rates were set by free markets. What the Federal Reserve does is enter the market as either supply or demand in order to keep the actual rate around the target rate. That has not been the case lately. But all in all, the rate cut was rather irrelevant, because the Fed Funds Rate has been trading below even the new rate of 1% for some time.

Federal Reserve on the Loose

For those who are praising this act as a boost for the economy are kidding themselves. I've never been a believer in the Fed's ability to drive a multi-trillion dollar economy by manipulating short term interest rates. That couldn't be more true in today's markets.

Not only can the Fed not control the U.S. economy through interest rate manipulation, they can't even control short term interest rates through interest rate manipulation. What this does affect are the rates tied to official fed funds rate numbers like savings account rates.

What this doesn't affect are any of the short term commercial paper markets used to finance economic activity. In essence, while the Fed is not affecting the interest rate markets, they are reducing savings rates and fueling inflation.

The Fed's Real Intentions

The Federal Reserve has dug in their heels in the mightiest bought against deflation since the 1930s. If they fail, we are looking at deflation that would dwarf that seen in the Great Depression.

In order to be successful in this fight, Bernanke and company will be forced to use all of their monetary tools, and some that were thought not to exist. The standard monetary tools have included FOMC policy and creation of money and credit.

Some of the more historic measures taken include: massive cumulative bailout, money market security blanket, commercial paper assistance, creation of more lending facilities that one can ever imagine, change in discount lending rules, direct stakes in insurers, direct stakes in banks, nationalization of privatized loss, etc. I mean at this point you could go on and on.

If it hasn't come clear to you yet, I don't know what to say. THE FEDERAL RESERVE IS ON THE PATH TO HYPERINFLATION. You need to prepare yourself financially. Things like social security will be worthless in 10 years. $100 of goods will soon buy you what would have been $10 worth. All of these things will weigh on us economically with higher interest rates and double digit unemployment.

Disclosure: The author and publisher do not hold stock in any of the securities mentioned in this article.

Comments

[Asbytec:]

I agree, but might say the Fed has no control.

Fed power money does not even scratch the surface. The Fed cannot print money fast enough to replace the dollars lost.

The correction is coming and I don't believe anyone can stop it. Best we can hope for is some level of mitigation.

However, God bless Bernanke, anyway. He's been the lone dog in this fight since October last year, or earlier.

2008 Nov 02 08:41 AM

[Asbytec:]

Do you really see hyperinflation? I see just the opposite coming.

Housing and oil prices are already down and the money supply is shrinking fast, or should be, irregardless of the liquidity the Fed tries to pump into the banking system. The credit markets are still stalled, and probably have to or should be for a while.

As far as a catastrophic depression? It's surely possible. I might argue it might be welcomed. The economy has been so tweaked on debt, a weak dollar, and huge trade imbalances. We've exported inflation far too long and have run sort of a pseudo, paper based economy far too long.

The economy needs a reboot. We need to reset the value of our currency, implement rules to prevent a run-a-way financial system, and get Americans back to some lower level of personal debt.

Again, it's coming. I don't think anyone can stop it. It'll hurt for a decade, but we'll come out the other end better off. The US will still be the world's strongest economy and, I predict, our currency will again be the strongest there is...in ten years or so. (Take three deep breaths and hold it.)

I've argued we're always behind the power curve. We got a stimulus package 6 months or more after I first saw Bernanke pleading with congress to keep folks in their homes and fix Freddy and Fanny. Congress didn't act then.

We got a bail out right after Lehman Brothers went under. Still, too late. We need a "new deal" right now...of course, well wait until it's far too late. Makes me angry.

2008 Nov 02 08:58 AM

[oldgoldbug:]

The FED will do everything it can (or can create) to keep the current monetary system working because it is the basis of power in our country. Without this functioning system there is no way to fund wars or institute domestic/foreign policies to please (pay off) special interests/constituents... Money = power and power must be retained at all costs.
I believe the author is right. I think the key indicator is the long TBond. Some bloggers have said the TBond may be the biggest bubble of all. I am beginning to agree. What a ferocious trap if investors are locked in at 4% while the inflation rate screams into the stratosphere. It would bail out the stock market and the real estate market in nominal terms as well, and preserve power for the elite, at least for awhile. Hyperinflation will wreak havoc unless there is a Volcker out there willing to take the hit with double digit interest rates.
Someone wrote that hyperinflations always end in deflation so the inevitable may be postponed for months or years. And there is always the possibility of a "soft landing" as occurred in the 80's and 90's.

2008 Nov 02 10:55 AM

[xpatUSA:]

The sad part to me (as a retired geezer with quite a lot of paper gold GLD) is that there is no discernible concensus on what will happen or when.

Today's posts predict deflation, inflation, hyperinflation, anarchy - all convincingly presented as our certain future here in the good old U.S. of A.

T.C.

2008 Nov 02 02:59 PM

[henarl:]

goldbug is right;
Hyperinflation is in our future but only when the Fed is no longer able to sell Tbonds to fools for less than high double digit interest rates. Government spending will never go down and paying off those horriblly increasing debts will only be possible with greatly inflated dollars. Your $100,000 30 yr. Tbond will probably be paid off at maturity with a crisp new $100,000 bill right off the press. You can then spend it all on a bag of groceries or a tank of gas. We are probably due for a few more quarters of deflation first tho.

2008 Nov 02 03:15 PM

[axelrod608:]

The Fed may be able to influence the economy in "normal" times when the economy is mostly sound, but experiencing some pressure here or there. That's not the current condition of the market. They have ABSOLUTELY NO EFFECT now, given how broken the economy is.

90% of the top financial institutions are insolvent. Nobody can prove it because of all the opaque level 2 and 3 "assets" and liabilities they have hidden off the books. But the real reson banks won't lend to one another is THEY KNOW THE TRUTH - the other guys are insolvent.

Hank and Ben are trying to empty the public treasury to bail out their good buddies. But the losses are too great - there's not enough money in the Treasury to cover their buddies' losses.

And we the sheeple, the taxpayers are going to get handed the bill and the shaft. While the rich scum that lost the Billions and Trillions walk away with a golden parachute.

The economy is Humpty Dumpty. The Fed, the Treasury, nobody can put it back together again. But they'll squander $Trillions trying to.....

2008 Nov 02 10:06 PM

[Asbytec:]

Yes, I have heard all sides, too. Hyperinflation, deflation, depression, recession, and soft landing. I don't believe recession is a question, anymore. Depression might be debatable.

At one time I prayed for a soft landing, and that is still in the cards. I guess it depends on how quickly we act and what we do. I fear we won't act in time, other than Ben, who some argue is behind the power curve, too. Maybe so, but he's light years ahead of everyone else, including the EU.

It seems we all agree the Fed is not able to affect much change. Think Obama can? LOL I dunno, for me the election is a crap shoot. Far more important are the actions taken in the financial world.

And it's scary, and not related to Obama as president, the very Muslim world we dislike, fear, and are at war with might be providing the capitol we need. Ah, but that's a topic for another day...

The impression I got from Hank was exactly as axelrod said. My gut told me he wants to bail out his buddies with our money. I am furious and argued for a grass roots, bottom-up bail out.

Spend that $750Bn on the home owner and small business. Screw the big guys and their skewed credit markets. Let it fail, we'll all be better off straddled with less debt. But, no, the world economy runs on debt. So, Hank and co want to get right back to business as usual: funding the world economy using US consumers and their credit cards. I pray every day this will not happen, and I am hopeful that prayer will come to pass.

There are smaller, solvent banks that might be ready to step up to the plate and manage our money without risky mortgage derivatives. It's to late to argue the point, but give our money back to us.

Save our retirements and mortgages and our small business jobs. Let the banks compete to pay us interest on the money we have left over. As it stands, the big financials will now charge us interest on our own tax dollars! They've made money hand over fist selling our productive assets, our homes, and our gold. Now, they want to mismanage our tax money? Treason!

Sorry, got off the subject. But, I guess I don't have those same ill feelings toward Ben and co and I do toward Hank and the Treasury.

Wonder where the dollar is going in 2009. My bet is further strengthening along with continued volatility. Trade with China is already dropping off putting fewer dollars into the forex, billions or trillions of dollars are being lost...vanished into thin air...poof! And the Fed cannot plug that leak. Credit is log jammed and hedge funds are being paid out in dollars. There are a few other reasons I am dollar bullish. Everyone is bearish on the EU majors. You?

2008 Nov 02 11:26 PM

[derryl:]

The US$ may be in rough shape but everybody else's money is worse. The Euro has a few members facing national bankruptcy. Western Europe is facing the same entitlement/demographi... fiscal wall as the US, and probably sooner. Saudi Arabia had to bail out one of its big banks. Japan's economy is stagnant and the yen relies on $US interest for a rate of return. The dollar rebounded because it's the best bet available. China's renminbi, backed by nearly $2 trillion of forex, might be the strongest currency around, but it's not open.

I'm waiting to see what the G20 (or G50 or however many Gs there are now) can come up with at the World Economic Forum. This time the central bankers will be accompanied by the political leaders of their countries. I don't know if that will make the outcome better or worse.

But I think the world financial system is in serious deep s___ and my guess would be a hard move toward world currency regulation. I'm pretty sure they will save the system, but at what cost to national autonomy I don't know.

2008 Nov 03 12:01 AM

[OctoberFaith:]

I love the first sentence in the third paragraph. I'm just gonna analyze it and stop right there.

what was your question? I'm sorry I missed it.

lets start over again, what is: Open market operations--purchases and sales of U.S. Treasury and federal agency securities?

The Federal Reserve's principal tool for implementing monetary policy. This is not a stock company this a global national level tool to effect some change, do you know what that change is?

2008 Nov 03 02:05 AM

[OctoberFaith:]

Alright that was a harsh burn, I am getting tired. I probably shouldn't have written that reply, that was a tad bit harsh to the author. they did after all take the time to write the article. my bad.

2008 Nov 03 02:06 AM

[OctoberFaith:]

"The short-term objective for open market operations is specified by the Federal Open Market Committee (FOMC). This objective can be a desired quantity of reserves or a desired price (the federal funds rate). The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. "

here I will ad this I feel bad for starting in on the author like that now, lol. it was stolen right of the federalreserve.gov home page.

2008 Nov 03 02:09 AM

[elwind45:]

This is "in the eye of the hurricane" part of our story. Any real capital injected into the system is clawed back into the banks reserves. This process is drying up the economy. The more the banks hoard the cash on its balance sheets the less inflation. However the White House is jawboning the banks to lend this money out. Once this extra cash reaches the economy hopefully productivity will have increased to meet it. Investments in alternative energy should continue as if "nothing has changed". Cheap energy and business investments thats what my get us going again. Now that the last couple of years has wiped out small business, Direct government investments in big business will be the policy.

2008 Nov 03 05:57 AM