Hanging in the Balance

Four and a half trillion dollars ... that's a lot of money for the U.S. Federal Reserve Bank to be carrying on its balance sheet. This liquidity is a function of the Fed's trying to keep the U.S. economy's head above water since the recession of late 2008 with "quantitative easing" ... because the fiscal side of this equation was non-functional. Now the Fed is thinking about unwinding this five-times expansion of this rotten nest egg since our last recession ... see: CNBC Article.

See also: What Could Go Wrong.

The questions that present themselves are: What does this mean? or What will be the ultimate cost of removing all this excess liquidity from our economy? and How might it be accomplished?

Let us take this last two questions first. The easiest (and longest) method would be for the Fed to stop buying any more mortgage-backed securities or rolling over government debt as it matures ... other than helping to service our federal deficits. This strategy could take as long as thirty years for the Fed to get its liability number below $1 trillion ... unacceptable since during this period there certainly would be a need for re-expansion. And the other downside is that removing all this liquidity from the U.S. economy at a much faster pace... particularly with the low monetary multiplier caused by the Dodd-Frank regulations ... would certainly cause major economic and stock market malaise. So, no matter how confident the Fed sounds about the ease with which it can work off these huge balance sheet figures, don't believe it.

And now the first question's answer: The Obama administration's reliance on monetary policy to extract us from our last recession means that this option has been removed for the next one. It is only aggressive fiscal policy, a return to painfully high inflation rates along with the lengthening of our national debt's maturities ... that have any hope of keeping our country solvent for our grandchildren.

So be prepared for one or more of these events.

Boxed In

The U.S. economy is ill prepared for another recession. In particular, on the monetary front, the U.S. Federal Reserve Bank has no leeway to reduce interest rates since it has not yet increased them after the last recession. And on the fiscal front, the federal government has little room for additional deficit stimulus since the government's debt is approaching critical levels ... see: Business Insider Story.

In this article, HSBC's chief economist, Stephen King (funny name for a doom-and-gloom sayer), lists four possible triggers for the next recession:

• 1) Wage growth will hurt corporate earnings and reduce the share of corporate profit contributing to US gross domestic product (it also doesn't help that worker productivity is low). In turn, households and businesses will lose confidence in the economy, and the "equity bubble" will burst with collapsing stock prices.
• 2) Nonbank financial systems such as insurance companies and pension funds will increasingly not be able to meet future obligations. This will cause a huge demand for liquid assets, forcing people to rush to sell despite no matching demand, triggering a recession.
• 3) Forces beyond the Federal Reserve's control, including the possibility that China's economy and its currency could collapse. Weak commodity prices could also cause collapses in several emerging markets, as could continued strength in the US dollar.
• 4) The Fed could cause the next recession by raising interest rates too soon, repeating the mistakes of the European Central Bank in 2011 and the Bank of Japan in 2000.

Or to simplify and summarize these reasons  -- domestic inflation, a liquidity crisis, an international monetary crisis, and a premature interest rate hike. This last reason is the rub ... in that, if interest rates don't go up soon, as initially stated by King, the Fed will have very little leverage to deal with the next recession. In other words, Fed Chairman Janet Yellen is pretty much boxed in.

How Many Angels …

can dance on Ben Bernanke’s head?  I just finished watching the Bernanke news conference after the Federal Open-Market Committee (FOMC) meeting yesterday and today … and a vigorous round-robin discussion on CNBC with about eight monetary policy experts.  All the while the stock market sold off over 100 points (at closing, it is now down over 200 points) and the yield on the ten-year note bounced around and then climbed to as much as 2.4%.  This was because Fed Chairman, Bernanke said that, if economic conditions continue to improve in the direction of internal Federal Reserve Bank forecasts, its quantitative easing (QE, or $85 billion monthly purchases of U.S. securities and mortgages) would begin to be scaled back later this year … with the possibility that they would end entirely by mid-2014.

What does this all mean?  Only Big Ben really knows … markets move not just on the absolute direction of interest rates … but on the first, second, and even third derivatives of same.  This is reminiscent of the middle-ages theological discussions about how many dancing angels could fit on the head of a pin … or the Talmudic discussions among Hebrew scholars about the implications of a single scripture word.

One thing investors might be able discern from this calculus … and that is, if Bernanke’s sage words do come true, the Fed will soon be "removing the punch bowl" and our economy should slow down … even from current anemic levels.  This means that the Democrats might have a more difficult time recapturing the House of Representatives in 2014 and maybe even holding onto the Senate … but then, because of the resulting economic bounce, they possibly would have an easier time retaining the presidency in 2016. 

And they say that the Federal Reserve Bank is not political …