Minutes from the Federal Reserve's January meeting were released today at 2:00 pm EST. The minutes indicate that the Fed plans to vary purchases based on the evolving economy.
At the time of the last meeting, the Fed believed the economy was mildly improving as a result of the fiscal cliff's partial resolution into the year's end and strong corporate earnings. The big question, then, is how will the economy have changed between the last meeting and the next Fed statement on March 20th?
Quick Overview Of The Minutes
*The minutes in general emphasized improving market conditions domestically and abroad, and continually noted concerns by some Fed members regarding the risks of loose monetary policy.
*The committee affirmed the efficacy of monetary policy, despite vocal but not formal doubts by some members, except one, Jeremy Stein.
*The committee agreed inflation was on target and high risk bonds spreads narrowed in relation to investment grade bonds.
*The committee noted that monetary policy will vary, possibly meeting to meeting, based on current economic developments.
*Several participants made note of the risk associated with the Fed's duration heavy portfolio, and showed concern over the possible capital losses if these assets are unwound.
Who Says What Matters More Than What Is Said
What is interesting about the minutes is the discussion at the FOMC meeting consists of non-voting and voting members. This means participants can often be quoted, yet have no voting influence on the direction of monetary policy for the time being. This point is worth noting because despite a relatively hawkish minutes report, where the Fed sounds overwhelmingly enthused by the economic improvement and fearful of overheating risks, current voting members are overwhelmingly dovish. Moreover, the most dovish camp happens to be the Fed leadership, who have permanent voting seats and the largest influence.
Can The Fed Go Bankrupt/Insolvent?
The last point in the overview regarding the one Fed member not being concerned about the impact of capital losses for the Fed is one of the more interesting yet easily overlooked parts of the minutes. The Fed is teetering on bankruptcy, with a mere $55 billion in capital compared to its massive $3.1 trillion dollar balance sheet. They are more than 500% more leveraged than the average financial institution:
The Fed member's point regarding the Fed not needing to worry about their precarious financial standing begs many questions.
Monetary policy watchers are quite aware that central banks don't need to go bankrupt when their liabilities are denominated in their own currency. The central bank can never run short of cash at the point of redemption, as dollars are non-redeemable. Redemptions out of Fed accounts just transfer from one liability item to the next. The Fed can also create infinite liabilities, which is effectively currency in its purest form.
This isn't to say capital losses won't effect the conduct of monetary policy. If the Fed has more liabilities than assets, that means the Fed is impotent to sell all their assets to absorb all their liabilities. On the margin, some money is in a sense stuck in the system, and cannot be absorbed by the Fed via asset sales. This has large implications with respect to inflation and the Fed's credibility and prowess.
What then is securing the mind of the one nameless Fed member voicing calm over possible Fed losses and their impact on monetary policy? Perhaps accounting gimmicks are being considered, such as that instituted by the Fed in early January of 2011, which allow them to report capital losses as negative liabilities to the Treasury, to whom they usually remit surpluses, instead of drawing against their capital account. This doesn't impact the reality of the situation, however, which remains that Fed losses in real terms cannot be made up for in asset sales. Public perception of the Fed and its need to acquire financing from the Treasury might not be impacted by real capital losses given some accounting scams, but the conduct of monetary policy will not be immune.
Where Are We Headed
Given the economy is headed towards another fiscal cliff of sorts, and interest rates have been on the rise, how should the forward outlook for the next meeting be seen? Given the economic headwinds, the continued rise in interest rates and its ability to threaten the Fed's "recovery," it seems likely the Fed will start to sound more dovish in upcoming meetings. Those genuinely expecting Fed policy to turn hawkish this year have not thoroughly considered the need for the Fed to cap interest rates. The U.S. economy is highly sensitive to higher rates given massive outstanding public and household debt. As rates begin to impact debt servicing and force deleveraging, the Fed will most certainly come to the rescue of bonds and support their own book and the economic variables they are targeting. The only question of uncertainty is do they preempt the effect of higher rates and dampen the yields before they cause trouble, or does the Fed wait for a collapse to justify their cause?
If the Fed is ahead of the curve, expect interest rates and the U.S. dollar to fall (UDN), the stock market (SPY) to do well, and precious metal prices to rise again (GLD), (SLV). Should the Fed be behind the curve, rising rates will strengthen the dollar, increase the real value of U.S. debts and send levered markets into a tailspin.
I'm guessing the Fed will get control sooner than later and risk trades will be formally back on. Seeing how bad the economic figures are between now and the Fed's March meeting are key to forecasting the Fed's next move. In any case, I see the Fed surprising markets in their resolve to maintain current policy and even strengthen their stimulus efforts at the first sign of economic disarray.