Mistakes are for Repeating

Mistakes are for Repeating

From Market Shadows Newsletter (11/25): From Fed, With Love, Event Horizons section.

How did the Federal Reserve precipitate the stock market collapse in 2008? Will it do it again?

By Ilene with Lee Adler of the Wall Street Examiner

The Federal Reserve is the largest driver of stock prices. Stocks as a group are less dependent on the health of the economy, or quarterly earnings, or world events, than they are on the actions of the U.S. Fed and other powerful central banks.

Lee Adler described the actions of the federal government and the Federal Reserve in causing the stock market meltdown in 2008: "The Fed has near absolute control over the US stock market and the economy based on how much cash it pumps into Primary Dealer trading accounts."

The Fed’s purchases [of Treasury debt] result in a credit to the Primary Dealer's account at the Fed, while the Fed’s sales result in a debit to that account. That’s how Fed purchases inject reserves into the system. The conduit is the Primary Dealer accounts. They then use that cash to trade their own accounts or lend to customers, pushing the markets higher when the Fed is buying on balance. (Lee Adler on QE-Infinity)

At the end of 2008, the government and the Fed panicked and pulled $700 billion out of the economy in raising TARP and funding it through debt sales [by the Treasury]. The Fed funded the debt through various "propping programs" that pulled enormous sums of cash out of the Primary Dealers' trading accounts. Draining the Primary Dealer accounts crashed the stock market.  The economy followed stocks into a tailspin.

 

The mechanism:

When the Fed buys securities from the dealers it pumps cash into their trading accounts, the market rises and the economy tags along. When the Fed drained money from dealer accounts, especially in the face of the Treasury selling $700 billion in new debt over the same time window, the economy collapsed.

It was just another one of the Fed's serial blunders. Some of its mistakes look good on the surface for a while, until the unintended consequences overwhelm the intended ones. That one went bad immediately.

I was shocked that the Fed would sterilize the alphabet soup programs that started with the TAF in 2007, by pulling the funds from the System Open Market Account (SOMA), thus crippling the Primary Dealers. I warned repeatedly that it would precipitate a crash, especially as the Treasury began selling over $100 billion a week in new debt to fund the TARP in Q3 2008. Bernanke fucked up, plain and simple. The Fed started to realize the mistake in November 2008 by starting direct purchases of limited amounts of GSE paper, but didn't go full bore until it started massive Treasury purchases in March 2009. That turned the market.

I'm well aware that correlation doesn't imply causation. In this case, cause and effect are easily observed. The effects of the Fed's actions are completely predictable now, just as they were in 2008. While the mainstream gives Bernanke credit for averting an even worse fate, the facts clearly show that his and Henry Paulson's panicked actions (not to mention then NY Fed President Tim Geithner) triggered a far more precipitous break than might otherwise have occurred.

Had the Fed not pulled cash from the SOMA, it is highly likely that the market would not have crashed and the economy would not have collapsed.

Once the Fed realized its error and resumed direct pumping to the Primary Dealers, the market and economy recovered to the trend level it would have been on. As long as the Fed kept the Primary Dealers flush with cash, the market and the economy responded in kind. Financial assets and commodities rallied and the economy followed along in a slow growth path.

At some point, however, inflation will tie the Fed's hands. Will it be this summer, when the Fed's MBS [mortgage backed securities] purchase program ends? (Lee Adler, quoted in Stock World Weekly, Apr. 2012)

The answer to that question was "no." In September 2012, the Fed initiated another quantitative easing (QE-3) program (colloquially called "money printing"). It announced that it would keep the MBS purchases going to a tune of $40 billion per month (reference).

Increases in inflation measures, such as commodity prices, have not stopped the Fed from artificially driving up asset prices in a way that promotes unsustainable economic growth. Bernanke thinks manipulating the stock market is a legitimate instrument for implementing its policy goals. It is conflicted. While its stated mandates are to keep prices stable and unemployment low, its masters have separate goals. "The Fed works for the banks, and the capital markets exist as a means for 'capitalists' to extract wealth from the public. Stock markets weren't started to enrich the public, that's for sure... The Fed has two clients, the US Treasury, and the banking system. It operates to keep them in business." (Lee Adler)

 

 

Stock market manipulation is a relatively new overt policy tool through which the Fed influences the economy. But propping the stock market up by creating more dollars and holding interest rates near zero (ZIRP) is not a permanent fix. It leads to price inflation in day-to-day necessities (food, energy), cuts interest income for savers, and sabotages plans of people living on fixed income and savings. The problems spread beyond national borders as prices for food and energy rise worldwide.

Wishful thinking aside, the Fed cannot print vast sums of money forever without the  unintended consequences "rising up and bite it in the ass."

But didn't Ben Bernanke and the Fed learn anything from former Fed Chairman Alan Greenspan's previous errors of increasing the money supply and driving interest rates lower?

He apparently didn't. Bruce Krasting observed,

“Bernanke never acknowledged that the Fed contributed to the mess of 2008. If Ben wasn't flat out lying, his head is buried very deeply in the sand.

“In response to the recession of 2001 the Fed allowed money supply to increase by 30% in 4 years. The Fed also manipulated interest rates, driving short-term rates (Federal Funds) to 1% in 2004. When Greenspan tried to normalize interest rates in 2005, he was forced to raise the Fed Funds rate 13 times. This sharp increase was a significant factor in blowing the top off of the real estate market. Greenspan’s Fed contributed to the housing bubble. The Fed's tightening brought on the bust that it helped create.

“So where are we today on the critical issues that brought about the collapse of 2008? Money supply is zooming. Inflation is chugging along. Interest rates are pegged at zero. The Fed’s balance sheet is bloated. The government is still making junk mortgages; FHFA is guaranteeing loans at 97.5% of value. Consumers are borrowing more. Debt has grown 6% in the past year, three times the rate of growth in the economy. Student loan balances have been exploding.

“The savings rate is the lowest it’s been since the crisis. Who would want to save money when the return on savings is negative? Junk bonds (and other forms of exotic debt) are back in style, and investors are lapping up the swill up. Funny money credit is back...

“For the Chairman of the Fed to stand before all those GWU students and avoid accepting a share of the responsibility for what happened in 2008 is a gross rewrite of history. That he does not see that he is making the same mistakes that the Fed made in every prior economic cycle is sad. The audience should have booed him. I am.” (Bernanke - 'The Fed never makes mistakes'. Recap from Stock World Weekly, Apr. 2012.)

Looking ahead, how will QE-Infinity play out?

QE3 purchases just started settling last week, so we have not seen the effects yet. Ultimately it will end badly, but in the intermediate term, bubbles should form in stocks and commodities and economic data may show accelerating growth for a few months. But at some point next year rising commodity costs will squeeze consumers and businesses to the point where businesses are forced to cut costs by laying people off. The Fed will then have found itself in a box where doing more of the same will exacerbate the problem, while if it stops QE, it would starve the markets of the cash to which they have become addicted, precipitating a crash. (Lee Adler)

The path appears to be set for higher prices in stocks and commodities, until the prices of commodities such as food and energy force a change of course. That change will take away much of the support under the stock market. Lee is suggesting that Bernanke can't balance this act and the result will precipitate a crash in equities. Bernanke probably thinks he can. That this time, it's different.

Read the full newsletter: Market Shadows (11/25): From Fed, With Love.