Terminal Velocity (28)“Disintermediated” explained how the Federal Reserve is monopolizing the provision of credit to the American economy; and insulating the banks from further economic risk as the US economy begins to slow. The Fed has effectively backstopped the banks and assumed all the economic risk going forward. This strategy and process creates a dilemma; as the Fed is now creating its own profits and risk simultaneously.
Medley Global Advisors started framing this new dilemma in the minds of the bond traders[i], in order for the discounting mechanism to provide feedback to the Fed on exactly what it can get away with. Richard Medley is now trying the wrestle the title of key Fed insider access node back from Jon Hilsenrath; as the latter’s halo slipped when he incorrectly backed Larry Summers candidacy for Fed Chairman[ii]. Presumably Medley’s edge is that he has privileged access to Janet Yellen as well as the major Global Macro Funds.
This framing of the debate was supported by the recent communication from the CBO on the expected trajectory of tax receipts[iii]. Close scrutiny of the trajectory projected suggests that the CBO is signalling that QE will extend until 2015, after which a recession will occur as it is wound down. If the Fed exits QE it will take a huge capital loss; but if it stays in the game it increases the size of the ultimate loss. The current position adopted is a kind of equivocal commitment, best explained by “Bull Dudley”, in which balance sheet assets will be allowed to mature as the exit strategy. If there has been no significant economic growth however, the Fed will find that it will have to reinvest the maturing proceeds. What has been deliberately understated by Dudley is that business will never invest for growth whilst it understands the enormity of the impact of a Fed exit. The “Helicopter Money” exponents understand this; which is why they advocate that the Fed must create a permanent increase in the Money Supply which mitigates the Exit.
The objective of the Fed is now to get markets to the point at which they accept the logical necessity of a permanent increase in the Money Supply. The problem with this strategy is that it will then ignite the increase in energy prices, which will effectively negate all the positive effects of the creation of the new money. The alleged abundance of US Shale Oil and Gas is supposed to give the Fed some comfort that the domestic economy can survive the next monetary policy induced “Oil Shock”. Since America still imports half of its Oil however, there should not be any comfort to be had.
What appears to be misunderstood, by the Fed, is the fact that energy prices are now the major driver of economic activity rather than interest rates; because interest rates are no longer a function of market fundamentals. Interest rates are set at artificially low levels; and for those who still can’t afford to borrow, the US Treasury has created various Federal loan modification programmes (aka “Acronyms” in the “Housing Smoke and Mirrors” Series) to allow them to roll over their debts. The cost of debt capital is therefore meaningless in economic terms. The cost of equity capital has also been made much cheaper, by the boom in equity markets as a consequence of the Federal Reserve’s QE programmes. In the absence of risk adjusted costs of equity and debt capital, the cost of energy becomes the main arbiter of economic decisions.
A cursory glance at Vehicle Miles Driven by Americans, shows very clearly that the cost of energy is the major economic driver. Periods of expansion in miles driven are always preceded by conditions in which the energy markets are weak. Periods of contraction in miles driven follow periods of extreme rises in energy prices. Americans don’t drive because they don’t have jobs; but it is also true that without cheaper energy the jobs won’t get created.
Fundamentally speaking therefore, the price of energy must fall in order to sustain real economic growth. This is the elephant in the room that policy makers are ignoring; or rather avoiding being transparent about. Rather than come clean about this, policy makers would rather throw money at an already unsustainable situation. By throwing money at the situation, they have succeeded in ratcheting up the costs of energy to levels that are unsustainable; thus even at the “Zero Bound” where capital is cheap energy is still too expensive.
In Terminal Velocity “Disintermediation” it was observed that:
“Captive central banks always resort to currency debasement as the last resort. Currency is less important than energy in a Developed Economy.”
The IMF has signalled its unease with this fact of life. In its latest warning[iv], it clearly opined the two possible outcomes of this policy inertia; whilst carefully avoiding the energy issue. Existing debt becomes unsustainable when there is no economic growth. A Government can then either confiscate wealth directly to pay down this debt; or it can create inflation to erode the value of this debt. Capitalist economies don’t do direct confiscation on principle, so they inflate. Clearly the IMF is feeling the down draught from the approaching rotor blades of “Helicopter Money”. This down draught is clearly blowing from the monetary policy committee meeting rooms of the world’s major developed central banks. With the support from the journalist community[v] it is now being framed as the rolling back of potential interest rate increases, in the face of slowing economic activity. As the downwind gets stronger, it will be framed as the case for more monetary easing.
It was interesting to see that the Fed actually supports the involvement of banks in the energy markets[vi], as long as it is ultimately in control of the capital deployed in these trading ventures. Given the links between economic growth, energy inflation and QE this would seem to be an absurd decision. When looked at more carefully, it signals that the Fed actually does get the point. It also signals that the Fed thinks that it will get control of the energy markets and hence economic growth, by allowing the banks that it regulates to trade in energy under its own guiding hand. The Fed’s balance sheet is therefore in the process of “expanding” to energy contracts. Control of the energy markets is the real prize. Perhaps the Fed is not as confused as we suggested in “Disintermediation”. The only way to guarantee an easy exit from QE, or the safe landing of “Helicopter Money”, is by controlling the price of energy. The Fed’s latest quest for this control may ultimately be cheaper than the trillions spent on the same objective by its Washington neighbour over at the Pentagon.