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For Stocks, Will To Commit Has Been Lacking

For Stocks, Plenty of Cash But The Will To Commit It Has Been Lacking

From Market Shadows Newsletter: Lights, Camera, Rally? (12/17)

Lee Adler of the Wall Street Examiner noted in "Fed Creates Nightmare Scenario, Closes Eyes, Sings Trololo" that on Dec. 12, the Federal Reserve elected to print an additional $45 billion a month via outright purchases of Treasuries.

That's in addition to the printing of $40 billion a month via Mortgage Backed Securities (MBS) purchases that it is already doing. It will also continue to reinvest the proceeds of maturing MBS. That's been running at $35-$40 billion per month. At that rate the Fed will be pumping at least $120 billion per month into the trading accounts of the Primary Dealers. This total is as high as during QE 1 in 2009. The dealers will use the cash to purchase more Treasuries, which will partly fund the Treasury debt. Other buyers will continue to fund the rest.

Primary dealers are investment banks which serve as trading counterparties of the New York Fed in its implementation of monetary policy. For example: Goldman Sachs, HSBC Securities, J.P. Morgan and Morgan Stanley (list here). In addition to purchasing more Treasuries with cash from the Fed, the Primary Dealers may buy MBS, stocks and commodities.

Lee surmised that the Fed created a "Catch 22" for itself by tying the Fed Funds rate to inflation, as it decided to keep the target range for the federal funds rate at 0 to 1/4 percent for as long as the unemployment rate remains above 6-1/2 percent with inflation no more than a half percentage point above its 2 percent goal. The Fed is not anticipating inflation to exceed 2%, as it measures it. However, we have argued that the Fed's measures are flawed and/or manipulated. Lee wrote:

...The Fed governors and bank presidents didn't see inflation surpassing 2%, EVER.

But what if, as I think highly likely, commodity prices surge as a result of this new round of money printing. Normally, in the short run, commodity price rises do not filter into the inflation measures which the Fed watches. Commodity price inflation could rage without pushing the PCE and core PCE to anywhere near the 2.5% threshold the Fed has set.

That has the potential to wreak havoc in the economy without raising employment levels at all. Manufacturers, middlemen and consumers would be squeezed by rising food and energy costs well before the Fed had any inkling of an increase in the tortoise-like PCE measures. The cost squeeze would force consumers to cut back on spending, and manufactures, distributors and retailers to cut back on employment. Inflation would stop economic growth, all the while the Fed is peering into its crystal balls a year or two ahead and seeing no inflation.

Then, as the economy ground to a halt, what would the Fed do? Stop QE because commodity inflation was crushing the economy? That would run the risk of exacerbating the contraction. Print even more money, driving commodities up even faster? In truth, if commodities do go into bull mode, the Fed would seem to have no way out.

In the meantime, Lee notes that more cash from the Fed will be injected into system next week. So while the market didn't celebrate Fed giving money to the Primary Dealers last week, it still can. There's enough cash to power that Christmas rally we've been waiting for. (For Stocks, Plenty of Cash But The Will To Commit It Has Been Lacking - Professional Edition)

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