Saturday, October 16, 2010

Chicago Fed Head Evans Strengthens the Argument that Short Term Rates Are in a Bubble

You may be aware that Chi-Fed Pres. Evans gave a pro-QE2 speech, He believes that the U. S. is in a liquidity trap. (For more on that phenomenon than most people want to know, click HERE for a link to the New York Fed on that subject.) Now, when they learn about a liquidity trap, most people would think that there's too much money around relative to investment opportunities.

But that's not what Dr. Evans and Dr. Bernanke think. Here is Evans:

If short-term interest rates remain near zero during this adjustment (Ed. that is, during QE2 = lots of money-printing), real interest rates would be between –2 and –3 percent. Perhaps that would be enough to improve labor markets and aggregate demand sufficiently, but I personally put more faith in analyses that suggest the liquidity trap is larger than this.

He is saying that he wants -- soon -- more negative real interest rates than -3%:

A variety of typical linear Taylor rules suggests around –4 percent. In addition, some calculations for optimal monetary policy simulations I have seen indicate that real rates of –3 or –4 percent between now and the end of 2012 would boost aggregate demand enough to deliver substantially lower unemployment by the end of 2012. . .

Over the course of this hypothetical adjustment, inflation is about 3, 4, and 3 percent from 2011 through 2013. Thus, policy can generate –3 and –4 percent real rates: This achieves a substantially higher opportunity cost of holding on to cash-like assets rather than lending and investing excess reserves in productive activities and workforces.

Of course, my concern is not how much interest a company makes on its cash reserves. Evans is saying that the average personal saver should be severely penalized because central planners such as he, and is the Comintern might have been, are unhappy with the business decisions that business people make. And the prudent savers must pay, just like road kill.

The truth, of course, is that higher prices only cause extra consumption in the form of hoarding, which sends the wrong signals to business, which has trouble distinguishing one-time increased demand such as from hoarding from organic increased demand. Also, the more that Fed policy steals real savings from savers, the more they turn to rank speculation, otherwise known as malinvestment. Hey, why not put some money into some friend of a friend's gold mine in the middle of nowhere? We're just going broke slowly with the money in the bank, anyway!

The deeper truth is that Messrs. Evans and all the other Fed bank Presidents work for a bank. Their interest is that the banks make money. So if they give the banks a continued cost of money of about zero, give them a little free money as interest on "reserves" (said reserves created when the Fed took assets off their hands at prices no one else would pay), and then, per Evans, give them the chance to charge higher and higher interest rates due to "inflation", well, then the banks can make more money, their bad loans can diminish in nominal terms, and everyone but savers and workers getting minimal to no wage increases can be happy.

It is a sick policy, but that's the plan.

Anyone who thinks that a 5-year Treasury yielding the grand total of $6 back for every $100 invested is prudent is entitled to his/her own opinion. In my humble opinion, the Fed is knowingly making all savers speculators. Why not at least keep up with Evans' high-inflation scenario with a 4% Treasury bond, with the chance for positive real returns if prices rise at 2% annually afterward, as he says he favors? And if by chance the U. S. goes Japanese anyway and we get true price stability, then one would have done OK with the 5-year note I just denigrated but one would do much better with the long bond.

Treasuries sold off on the long end last week on the above sort of talk, while the 2-year did not budge. Yet Evans and Bernanke are talking about 3+% inflation well within the 2-year time frame, so logically the short end should have sold off big-time, not the long end. Nothing has changed regarding years 11-30, though. We continue to have no idea what the future will look like then, though some of us won't be around to see it!

Thus the sell-off on the long end was speculative and can be bought speculatively. We are approaching the 4.1% intraday low of the 30-year in 2003, which may offer resistance now that we are so far into the next economic cycle.

Of course there are many risks with 30-year securities, but for quite some time I have been suggesting that gold and other hedges such as silver and foreign currency-denominated debt instruments are the best ways to deal with highly inflationary Fed policy in this era of the inherently deflationary credit collapse and its aftermath. I'm still long lots and lots of that sort of stuff, though I just sold the last of my silver yesterday on a timing basis.

The overvaluation of Treasuries-- i. e. the "bubble"-- is in the short end with 0.36% two year notes and 0.59% 3-year notes. Most bubbles go to greater extremes than to end with a rather boring 4% long bond. Let's see if we get 3-3.25%%. If it occurs at any time in the next 5 years, a buyer Monday at 4% will do just fine.

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