The Fed’s Worst Fear

The year-end “fiscal cliff” tax deal sent shivers through the bond market, driving 10-year Treasuries to the lowest level since last April. There was a good reason. The stubborn resistance by Barack Obama and Senate Majority Leader Harry Reid to spending cuts left no further doubts about their lack of interest in the nation’s number one economic problem, the massive federal budget deficit.The bond market decline came despite the Federal Reserve’s renewed program to gobble up yet more government debt. Presidents of some regional Federal Reserve banks are growing nervous about that, judging from December minutes of the Federal Open Market Committee, which guides Fed policy. Specifically, they are legitimately concerned that continuation of the Fed’s manic buying—now running at $85 billion a month in Treasury and agency paper–will ultimately destroy the dollar and maybe the central bank itself. The inside look provided by release of the FOMC minutes didn’t cheer the bond market either.These are signals of dangerous times. Forget about the next Washington dog and pony show that will come when the rapidly swelling national debt bumps the statutory ceiling next month. The bond market (“bond vigilantes”) will dictate the future of U.S. monetary and budgetary policy. Bond markets only obey the rule of supply and demand. When the flooding of markets with American debt causes the world to lose confidence in dollar-denominated securities, we are in trouble. The only force standing in the way of that now is the Fed. But the regional Fed presidents are prudently asking how long that can be sustained. It is a very good question. .President Obama currently is riding high, pumped up by his re-election and success in steamrolling Republican budget-cutting demands during the “cliff” talks. He clearly doesn’t understand that the deal does nothing to relieve the present danger. His millionaire tax, an artifact of class-warfare politics, will produce scant revenues. The money he will extract from American pocketbooks with the expanded payroll tax will curb consumer demand, further slowing already weak economic growth. Only entitlement reforms, which Mr. Obama refuses to consider, can shrink the deficit enough to reduce the danger it poses.The Fed’s worst fear is that despite its long-term commitment to buying up government debt, it will lose control of interest rates anyway. That’s why the early-January upward blip in bond yields flashed caution. If Treasury bond prices decline significantly from the artificial levels massive Fed buying has supported, several things will happen, none of them good.First of all, government borrowing costs will rise, making it even more difficult to control the deficit. Second, the Fed’s gargantuan and growing $2.6 trillion portfolio of Treasury and government agency mortgage bonds will lose market value. It won’t take much of a fall to wipe out the system’s capital, making it a ward of the Treasury and costing it what little independence it has left to defend the dollar.Even now, in the absence of any shred of White House fiscal responsibility, the Fed faces a cruel dilemma. It can reduce market support, let bond prices fall and suffer the unhappy consequences. Or it can keep on its present course of trying to satisfy the beast by buying up further trillions of dollars in Treasury paper. The latter is the current course preferred by Chairman Ben Bernanke and Board of Governors bureaucrats notwithstanding the worries of regional Fed presidents..That course inevitably leads to inflation. Over the last four years, the damage to the dollar has been partly ameliorated by global investors fleeing weak currencies elsewhere for the relative safety of the dollar. But there has to be a limit to how long that will be true. We already are seeing signs of renewed asset inflation not unlike the run-up that occurred in the first half of last decade. Stocks and farmland are up and housing prices are recovering from their slump.The wealth illusion from asset price inflation makes it insidious. Brendan Brown, London-based economist for Mitsubishi Securities, reminds us that asset inflation is usually followed by asset deflation, and that’s no fun, as the events of 2007 and 2008 testified. More seriously, asset inflation often presages a general rise in the prices of goods and services.Inflation can ultimately destroy the bond market, as it did in 1960s Britain when the socialist Labour Party was trying to save its sinking boat. No one wants to commit to an investment that might be worthless in 30 or even 10 years.Yet, through history, governments have inflated away their debts by cheapening the currency. That process is well underway in the Fed’s abdication to irresponsible government. If Fed policies continue, another huge tax, inflation, will weigh down the American people. The politicians will try to escape public censure, as they always do, by blaming it all on “price gouging” by producers, retailers and landlords. A substantial cohort of the press will buy into that phony rationale and spread it as gospel.The Fed’s dilemma is in fact everyone’s dilemma, given the universality of the dollar. And all because an American President and a substantial number of senators and representatives don’t understand one simply fact: In the end, the bond market rules.

The Fed’s Worst Fear

The Fed’s Worst Fear

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