Do Nothing, Even if it's Wrong?

The degree in which a measure is necessary, can never be a test of the legal right to adopt it; that must be a matter of opinion, and can only be a test of expediency. The relation between the measure and the end; between the nature of the mean employed toward the execution of a power, and the object of that power must be the criterion of constitutionality, not the more or less of necessity or utility. ... - Alexander Hamilton, 1791


This week, as we all saw, the Federal Reserve's Open Market Committee (FOMC) narrowly avoided a unfettered opportunity to do the right thing. Instead of taking the action to slow the purchase of treasury bills (an activity which Bernanke himself referred to as 'easing up on the accelerator'), it's full speed ahead into 2014.

This is an admission that the economy is not recovering. This is a fact we all knew, but does not constitute a reason to "distaperfy" (the Fed inspires a lot of new words these days). The conclusion that should have been made from observation of facts available to all of us is that this extraordinary distortion of the bond market is not helping the economy.

It is as if the committee is watching the speedometer, forgetting that they were just supposed to go to the corner store for a gallon of milk. Sometime before the end of the year, they will leave the solar system. Everybody else knows the speedometer they are reading no longer has a relevance to this economy. So, why do they continue to press on? Surely it is harder to do nothing.

One clue is that it actually turns out to be a profit center for the Treasury. Warren Buffet calls it the greatest hedge fund in history. Since the Fed "owns" all of the bonds, it is returning all the profits back to the US Treasury.  Heck, 80-90 billion dollars a year come right back into the till. Not only is the government financing their debt, they are actually getting it all virtually for free. What a system!

A taper of any kind will be a signal that the game is up; that the government will have to start paying for its debt. This is a serious problem right now, because (1) interest rates were creeping up with the hint of a taper, (2) we are already at the debt ceiling. So, the FOMC is essentially hedging for the US Treasury; and somehow feels it needs to continue to provide cover for this scam.

The weaker data will continue to trickle in, and the Fed will use it to further monetize the debt, but when the game does end, it will do so not based on what the government thinks, but based on what the market thinks. Right now, the market doesn't know what to think. If interest rates stay below 2%, stocks continue to look cheap; but when the corporations are done buying their own shares for lack of anything better to do, the earnings will take over. With the economy still in a down mode, lower productivity produces lower incomes, and that leads to lower consumption.

Lower consumption leads lower earnings, and then the stocks will start to look expensive. Meanwhile, if the Fed continues to soak up 1/3 of the bonds, it means that the smart money could start leaving the US. That's going to leave a mark, exacerbating the problem now with a declining dollar. It would be a different matter if we were positioned to leverage exports. Unfortunately, we are not. We import a lot, and it will all be more expensive. That will look an awful lot like inflation when it comes.

The fed has this inflation wish going on. Bernanke is decidedly fearful of deflation, so he has jammed the gas pedal to the floorboard. Deflation is probably what the doctor ordered; but even if you don't agree, inflation is hardly a desireable result. Thinking they were facing a damned if you do, damned if you don't moment, the Fed has probably damned us to a raging inflation before the next bubble pops..