The Federal Open Mouth Committee Is Back in Action

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Hawks (relatively speaking) and doves within the Fed are busy trading slightly contradictory statements in public again, in a performance that is eerily reminiscent of the "exit talk" (exit from unusual monetary accommodation measures, that is) that proliferated about one year ago. This time it started off with Charles Plosser mapping out his preferred retreat from QE. We have previously mentioned that Mr. Plosser is among the few Fed officials occasionally capable of making sense (others include Thomas Hoenig and Richard Fisher).

Plosser's analysis of the labor market's difficulties -- and his conclusion that overcoming said difficulties by means of monetary pumping was not possible -- was a breath of fresh air. Even though Plosser is only getting the story partly right, one would at the very least have to conclude that he does not believe the Fed can actually fulfill its secondary mandate of keeping unemployment low. For a Fed official, that is an almost revolutionary admission. Whatever Plosser's qualities as an economist, though, everyone working at a central economic planning agency is ultimately faced with the problem that such planning is entirely futile.

There is always one way of getting decisions right by sheer luck or coincidence, while there are millions of ways of getting them wrong. The Fed is not part of, but operates outside of, the market economy and can never possess the omniscience that would be required to ensure that its decisions are correct. Bob Prechter once noted that, in his opinion, the Federal Reserve is actually not a rate-setting agency but a rate-following agency, which he tried to prove empirically by showing a chart of the T-bill discount rate superimposed over the Federal Funds rate – and sure enough, the T-bill rate leads and the FF rate target follows:

[Click all to enlarge]

The three month T-bill discount rate vs. the Federal Funds rate target, via

However, we believe there is a flaw in this reasoning. What Prechter fails to account for is that there is a feedback loop between the market-determined rate and the Fed's rate-setting decisions. The market at the shortest end of the yield curve tries to anticipate the Fed's moves, and is evidently very successful in doing so.

However, the correlation depicted in this chart is not necessarily immutable. At some point in the future, a divergence between the two data sets may well emerge, since other market data could influence the T-bill rate in defiance of the Fed's policy objectives and concomitant rate-setting decisions. Moreover, the fact that there is a feedback loop at work can be proved by observing the federal funds futures market. These futures represent the market's best guess of the probabilities of future changes in the administered rate target, both in terms of timing and size. In the short term, this market frequently errs by a wide margin. It is also a market that has historically been highly sensitive to Fed talk.

Another factor overlooked by Prechter is that a rate target is used to supply or drain reserves via the interbank funding market, and will thus periodically accommodate increases in the money supply when credit demand threatens to move the effective rate above target. In other words, the implication that there is actually no planning going on is wrong, since these additions to the money supply erect a kind of Potemkin village of non-existent savings, i.e. they masquerade as additions to the pool of savings, with the explicit aim of boosting economic activity (which they do in the short term, but unfortunately it is wasteful activity that undermines real wealth creation).

Anyway, there clearly are differences between the individuals populating the monetary bureaucracy, and they are more starkly on display these days than they used to be. This should be no surprise, as the extraordinary policies pursued since the 2008 crisis are apt to be divisive. Plosser is undoubtedly the most hawkish voting member at the FOMC this year and he's clearly worried that QE has gone way too far. As reported by Bloomberg:

Federal Reserve Bank of Philadelphia President Charles Plosser laid out a strategy for withdrawing record monetary stimulus and said the improving economy means policy makers should consider how to exit.

The central bank should set a pace for selling its mortgage and Treasury holdings in conjunction with raising interest rates, Plosser said today in a speech in New York. He suggested selling $125 billion for every 0.25 percentage-point rise in the benchmark rate to almost eliminate $1.5 trillion in bank reserves.

This was last Friday and the markets actually showed a mild reaction, with the dollar strengthening a bit, precious metals coming under a little pressure and stocks surrendering a sliver of their earlier gains. In short, the markets don't really seem convinced that Plosser's ideas stand a snowball's chance in hell of being implemented anytime soon. It seems he is rather seen as a curiosity in the Hoenig mold, the lone hawk in a flock of doves.

In the meantime, however, other Fed officials have come out as well to warn that there is at present little chance of QE2 being followed by an additional monetization program. Not surprisingly, Richard Fisher comes closest to Plosser's views, and has made it known that he will most definitely vote against an extension of QE. His distaste of QE is even palpable in his choice of words – he calls it 'that program."

According to Reuters:

"I will vote against … any further extension of that program," Fisher said in an interview on Fox Business.

"I cannot foresee a circumstance where I can support any further liquidity in the economy."

Fisher is a voter this year on the Fed's policy setting panel, and has said before he would object to continuing the Fed's $600 billion program beyond its scheduled end June 30.

The Dallas Fed chief said the economic recovery is self-sustaining but is "too slow for comfort.”

More hints were then dropped by John Bullard, who sounded surprisingly hawkish as well, suggesting that QE2 should actually be curtailed (he has no vote at the FOMC this year, but his input will certainly be considered). This is surprising because he previously frequently invoked the Japanese deflation bogey, fearing it was lurking just around every corner.

Said Bullard:

If the Fed opts to start withdrawing stimulus and tighten policy, it should start with the “balance sheet” by selling bonds first, then changing its wording about keeping interest rates near zero for an “extended period” and then raising interest rates, Bullard said.

Bullard has warned since last July about a risk of Japanese-style deflation in the U.S. while calling for purchases of Treasury securities to reduce the threat.”

On the other end of the spectrum we find the über-doves Charles Evans and Eric Rosengren (Evans has a vote this year), who seem definitely set against an early expiration of QE2 and wheeled themselves out as a counterpoint to the putative hawks. Note, though: While set against an early expiry of QE2, both of them seem to have made their peace with not starting QE3 right this second. Evans actually managed to inject some unintentional humor into his remarks, unwittingly illustrating the insurmountable problems faced by central planners.

Two Federal Reserve regional bank presidents voiced support for the completion of the central bank’s $600 billion Treasury securities-purchase program through June, saying it’s too soon to remove stimulus from the economy.

Boston Fed President Eric Rosengren said yesterday that high unemployment and low core inflation mean record monetary support is still necessary. Chicago Fed President Charles Evans said he believes data suggesting a more sustainable recovery won’t prompt an alteration in the bond-purchase program.

“It could be that $600 billion is just about the right number,” Evans told reporters before a speech in Columbia, South Carolina. “I won’t be surprised if that in fact is the decision. I still think it is a high hurdle to stop short of $600 billion. So far I haven’t seen it.”

Their remarks highlight the difference of views that has emerged since the Fed’s March 15 meeting, when policy makers kept in place the plan to buy bonds while concluding the recovery is on “a firmer footing” and the labor market is “improving gradually.”

It "could be $600 billion is just the right number"? This is the extent of the guessing game that informs the masters of the printing press. It would be really funny if it weren't such a horrid policy. Why not $650 billion or $700 billion or any other huge number pulled out of some hat? What Evans essentially admits is that they have not the foggiest idea what they're doing.

As far as we're concerned, the only thing that can really be said with authority about the printing of $600 billion is: "It's exactly $600 billion too much." Increasing the supply of money confers absolutely no benefit to society at large. It will help enrich a select few, but it contributes nothing to real wealth creation. On the contrary; the economy must be expected to suffer additional structural damage as more malinvestments are piled up that will eventually have to be liquidated again in another painful bust.

What to Conclude

The sudden onslaught of Fed verbiage is surely no coincidence. The Fed has been criticized far and wide for its inflationary policy, and this political backlash -- combined with growing fears among officials that the famed "inflation expectations" may actually be about to get out of hand (verbalized here by Jeffrey Lacker) -- have now led to this campaign of advance burying of QE3 by means of QE2 funeral eulogies. Surely QE3 won't be talked about so much anymore if even QE2 comes under official scrutiny.

Since the current QE program is slated to end in June, market participants are given fair warning not to expect more coups de whiskey for the stock and commodity markets immediately thereafter. This in turn means that the times are set to become slightly more interesting.

Given that there is not the slightest evidence yet that private sector deleveraging has run its course, a cessation of excessive monetary pumping may end up stopping various bubble activities in their track in very short order. This is to say, both financial markets as well as the economy may slump again fairly quickly. The experience of the inflation experiment in post-revolutionary France in the late 18th century serves as a good example: Initially, the inflationary policy seemingly revived commerce, but every time it was temporarily abandoned, the revival died a sudden death again. This in turn seduced policymakers to revert to type and do it all over again – an outcome that is probably already preordained in our current case as well.

Helicopter pilot Ben Bernanke has been rather quiet, letting the rest of the board spread the message. Alas, we suspect he's personally still firmly in the pro-easy money camp. At least this is what we would have to conclude, considering his well-known views on the Great Depression as well as Japan's post-bubble era. His usual refrain was that policymakers were too timid in these instances, but as it were, the BoJ is a veteran of two (now 2.5) QE programs as well, so if one wants to be "less timid," then QE1 and QE2 alone obviously won't cut it.

In that sense we would be inclined to discount the advance funeral rites for QE3 as just more hot air. Nevertheless, there will be a pause, and should the economy's momentum not falter again immediately, then we'd expect the "exit" palaver to increase in both volume and frequency.

Coppery Shenanigans

Somehow we don't see how any of that would be good for copper in the mid 4's or the SPX at its current lofty valuation. Speaking of copper, here is some interesting information on how copper inventories are used as collateral for loans that are then invested in unrelated speculations (mostly in property) in China. Apparently some people at Standard Bank think this is cause for concern.

Anecdotally, something in the region of 600,000 mt of refined copper is currently sat in bonded warehouses in Shanghai, with perhaps another 100,000 mt in the southern ports. This is equivalent to around 11% of China’s total refined consumption and around 40% of China’s net refined copper demand.

Bonded stocks have climbed by around 300,000 mt since the beginning of this year, pointing to the absence of end use demand at the moment. The amount of metal is so high, that spare capacity at some bonded warehouses is running out, with some metal being stored outside.

The scale of the refined inventory casts into doubt the size of the expected refined deficit in the copper market this year, and raises the prospect of a balanced market, or even a small surplus.

More worryingly however is that the primary use of copper in bonded warehouse appears to be as a financing mechanism to provide cheap working capital for various types of business often unrelated to the metallic industry.

Initially via a letter of credit and then by using deferred payment LC, they create a borrowing vehicle. Estimates for the amount of metal tied up in such a way range from 40-80% of total bonded stocks. Our estimates are towards the upper end of this range.

Property developers (or the property developing arms of conglomerates), appear to be behind the lions share of this type of activity, driven by an unwillingness by domestic banks to extend finance, or the imposition of interest rates of anything from 10-20% when they do. On that basis, interest rates on metal of LIBOR + cost of funding look very attractive indeed.

This doesn't sound like something that will end well. We bring it up specifically because the bull market in copper is representative both of the huge wave of monetary inflation that has been unleashed by central banks since the 2008 crisis as well as the extremely high degree of economic confidence that currently obtains. Without more QE from the Fed, and with the PBoC continuing to tighten policy via hiking reserve requirements (with the effect that money supply growth has begun to slow dramatically in China in recent months), this strikes us as one of the more vulnerable markets, and one that will likely provide an early warning signal if things are about to go awry.

Copper and the U.S. stock market – joined at the hip. Note the divergence at the summer 2010 lows. A similar divergence may develop at the next intermediate-term high (there is actually a small divergence already, but it is not pronounced enough yet to cause alarm). Dr. Copper used to be the metal with a PhD in economics … now it's the metal with a PhD in excessive leverage.