The Fed's Big Gamble

by Dirk van Dijk

The Federal Reserve is in the process of buying up to $500 billion in mortgage-backed assets. Not exactly the "troubled assets" that the TARP was supposed to buy originally. These assets are backed by Fannie Mae (FNM) and Freddie Mac (FRE). Since Fannie and Freddie have effectively already been nationalized, it is almost like another form of government debt.

However, under normal circumstances the Fed only buys very short-term paper in conducting monetary policy. This paper will be of much longer maturity. It will also be more targeted towards the housing market, and should help to drive down mortgage rates.

How will the Fed pay for it? With the printing press, of course. The Fed is desperately trying to pump up the money supply (M). We are currently going through a big deleveraging, where everyone is trying to pay off debt and hold onto their cash as tightly as they can. This is true of corporations, individuals and most significantly banks.

This slows down the rate at which money turns over, or its velocity (V). One way of computing nominal GDP is the supply of money times how quickly it turns over, or M * V = P * Q, with P representing the price level and Q representing the quantity of output.

Thus, if V goes down, we will see either a fall in prices or a reduction in output. Right now we are seeing both, with a rapid decline in most measures of inflation and a rapidly slowing economy.

Therefore the Fed is trying to offset the decline in velocity with an increase in M, and is doing so at a very unprecedented rate. The monetary base typically grows by between 5 and 10% per year. Since 1959, the previous highest year-over-year change had been 16% in the run up to Y2K, and this was quickly reversed. It is now running a rate of over 75%, with virtually all of the increase coming in the last few months.

In August, the monetary base stood at $840 billion; by the end of November it was up to $1.44 Trillion. The process of buying these mortgage-backed securities will simply accelerate the process. This is a daring gamble on the part of the Fed, but most likely one that it needs to make, to prevent the total collapse of the economy.

However, if the economy starts to stabilize, the Fed will have to just as aggressively drain this liquidity out of the system. It will have to do so when the economic picture is at its bleakest (we are not there yet -- not by a long shot). If it doesn't, the risk of very high inflation (much higher than Ford/Carter levels) is huge.

I suspect that there will be a very rapid switch from deflation to high inflation, but that it will not occur until early 2010 at the soonest. When that happens, anyone holding long-term bonds, especially Treasuries will be decimated. Mining stocks, particularly of precious metals, like Newmont Mining (NEM) and Barrick Gold (ABX) will be huge winners in such a scenario.

Comments

[nova:]

It is a gamble when a government controlled economy supposedly be more effective than a market economy.

In the past, a government controlled economy has always failed regardless when and where it was tried/imposed. Bailouts of failed businesses have never contributed to an economic progress. It just postponed the inevitable making a bad situation much more worst.

2008 Dec 31 03:42 PM

[jepittman:]

Your outlook is quite plausible, especially the part about the economy stabilizing. If conditions play out similar to your scenario, the S&P should have a very good 2009. I do not see how the economy can transition from recession to economic stability to inflaton without equities moving substantially higher.

2008 Dec 31 04:49 PM

[prudentinve...:]

Interesting to see how the fed's actions are frequently described in heroic terms. You put it as "..This is a daring gamble on the part of the Fed,..", which sounds brave, adventurous, and dashing.

Whenever the fed cuts rates, the mainstream media call the move "bold". In many instances, however, the rate cuts are priced-in by the market before the fed meets, and the market has thus put them on notice that failure to cut would "disappoint" and tank the market. So the fed dutifully cut, and the media rewards them by extolling their boldness, even though "bold" in these situations is certainly not the right adjective!

2008 Dec 31 05:02 PM

[Kaleb22:]

Good article, there is no doubt gold will go up, but how much is the real question.

2008 Dec 31 05:08 PM

[Lin:]

Good article .

The real question is however , Is if gold , the true economic barometer , starts to skyrocket , won't the Fed suppress it's price , as they already have been doing ? Will they also confiscate the PM as FDR did in similiar economic times in the 30 's ?

2008 Dec 31 05:26 PM

[Lin:]

an add-on to above

Paul Volker , past fed chief + now on Obama's econic team has stated in the past , " In the 70's , we let Gold get out of control , that was a mistake ".
For sure the fact he is on the new economic team , is not good for Gold . Alan Greenspan also once said , " gold is a true way of protecting one's weath ".The goverment does not want ordinary citizens to " have a means of protecting themselves financially ". This is why they work so hard to suppress the true Gold / Silver prices .

2008 Dec 31 05:32 PM

[don pedro:]

We now have the worst of the 2 big economic systems at work in the U.S. The worst of capitalism in that fraud, corruption and failure to enforce even the most basic regulations is the norm, and the worst of communism where companies that deserve to go under are being propped up with government (as in you and me) money in order to continue losing money with their bonehead CEO's that are mostly still in place.

The founding fathers are spinning in their graves.....

2008 Dec 31 08:54 PM

[Steven Hansen:]

M * V = P * Q is like a concept - not a formula. it is used to show how subtle changes in money or velocity effect prices or supply/demand.

there is nothing subtle about what is going on. in reality at this point, the M * V component yield is not much different than at the beginning of 2008, but P * Q is very different.

there are many factors which effect the economy, and the price of gold. this should be a very good year for gold.

2008 Dec 31 08:58 PM

[icandoitdon:]

"However, if the economy starts to stabilize, the Fed will have to just as aggressively drain this liquidity out of the system. It will have to do so when the economic picture is at its bleakest (we are not there yet -- not by a long shot). If it doesn't, the risk of very high inflation (much higher than Ford/Carter levels) is huge."

there is a simple but fundamental truth here. inflation is not a hindrance to a debtor nation...indeed, inflation is the debtor's friend. now you tell me....do you really think our federal reserve has any intention of reversing it's easy money policies that they and the treasury have deemed our economic lifeblood?

our country can't seem to function without cheap credit for everyone...deadbeats included. unless forced to reign it in by our foreign creditors, cheap money and easy credit policies are here to stay.

china and japan will have more to say about our economic future than our federal reserve.

2008 Dec 31 10:27 PM

[GloomBoom.com:]

There is no question that inflation is on the way. The only question is when. This will be bullish for gold. The idea that the Fed can reverse the inflationary trend quickly is overly optimistic.

2008 Dec 31 11:26 PM

[investor88:]

Useful article. Recognises the cycles inherent in nature. Now deflation then inflation in a year's time!

Jan 01 04:07 AM

[wpdragon:]

I agree and think commodities and early cycle industrials will be good trades here on a weaker dollar


On Dec 31 04:49 PM jepittman wrote:

> Your outlook is quite plausible, especially the part about the economy
> stabilizing. If conditions play out similar to your scenario, the
> S&P should have a very good 2009. I do not see how the economy
> can transition from recession to economic stability to inflaton without
> equities moving substantially higher.

Jan 02 12:16 PM