Could It Turn Out to Be the Fed's 'Operation Twist of Fate'?

By Reid Holloway and Robert P. Eramo  NOV 19, 2012 9:07 AM

Oddly, given the convergence of many significant factors, it's quite possible -- completely contrary to prevailing viewpoints -- that the Fed's actions may have been too restrictive.


MINYANVILLE ORIGINAL With notable exceptions including David Einhorn and John Paulson, most people learned the hard way that you can’t take it for granted that real estate just goes up every year without interruption, although for a very long time that seemed to be a reliable idea.  What followed the mortgage meltdown of 2007-2008 was the biggest intervention of government—any government, anywhere, in history—into the financial markets and banking system, and this especially includes the three-phased “quantitative easing” QE1-QE2-QE3 monetary expansion conducted by the Federal Reserve Board, with the most recent phase now including purchases of mortgage backed securities and derivatives.  In the phase just prior to that, the Fed conducted something called “Operation Twist,” the simultaneous purchase of long-term treasurys against sales of short-term treasurys in the attempt to push down long rates at the expense of short term rates; i.e., “twist” the yield curve into making long-term borrowing more attractive to borrowers, believing this would stimulate real estate investment and the general economy.
These nuances aside, a whole lot of money has been introduced into the economy in the hope that the lending freeze that began with tumbling—and then completely frozen and illiquid—mortgage backed securities and their derivatives could be thawed, and ever since then, Austrian School monetarists have been crying foul and warning of the inflation dangers. 

Others such as David Stockman, formerly President Reagan’s Director of the Office of Management and Budget, have accused the Fed of destroying the commercial lending business by guaranteeing large banks a return on the so-called “carry trade”: transactions by the “privileged few” among these institutions able to borrow fiat money at essentially no cost in order to purchase government bonds and thus pocket a 150- to 200-basis-point spread.  The result, Stockman says, is completely removing the incentive to loan to commercial borrowers—that is to say, businesses and employers.
Here is an example of one of the more restrained things that have been said about Ben Bernanke and quantitative easing:

“…there is a downside to flooding the economy with new money: inflation.  If you have more dollars and credit chasing roughly the same amount of goods and services in the economy prices will go up.  And although it can take a while to see that inflation emerge in the economy, it often shows up immediately in commodities, which investors often turn to as a hedge against inflation.  Hence the meteoric rise in the price of gold, which has stabilized somewhat lately, and, of course, oil.”
-- Merrill Matthews, Contributor, Forbes, March 22, 2012

Indeed, for some people, words are simply inadequate for what they feel they need to express, as with this $20 shirt available at

That’s got to say something right there, doesn’t it?  A T-SHIRT scorning the Chairman of The Federal Reserve Board, a figure who has over the Fed’s 100-year history  traditionally been obscure but today is not infrequently referred to as “public enemy number-one,” the “savior of the economy” or even “more powerful than the president of the United States.” Then one day the man who is sharing my byline with me today asked me if I look at the numbers the Fed releases on Thursday afternoons, the money supply numbers.  My not completely flippant response was that I normally do not, for the following reasons: (1) everyone knows money stock is growing rapidly and that fact is priced into the markets (2) the Fed doesn’t target money supply; it targets interest rates, especially as that relates to the carry trade designed to keep the large money center banks—Citigroup (NYSE:C), JPMorgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC) and Bank of America (NYSE:BAC), who still hold about half the total value of the nation’s outstanding home loans—well liquidity nourished.  That was my then under-informed mindset.
“That’s not what I’m talking about,” Bob Eramo continued.  “What I’m saying is that if you look at the important measures of money stock, the growth rate is not as alarming as the Austrians would have you believe, and it has slowed dramatically more recently.”  So I proposed that we do some research downloading data from the Fed’s website, and that I would assemble it in spreadsheets, make some calculations and then we could take a look at the results.  Bob is one of those great guys—a math whiz, a licensed top-notch actuary and even a physicist (Bob received his B.S. degree in physics and mathematics from Brooklyn College in 1970)—who proves why it’s always a wonderful experience to work with smart people: They tell you everything you need to know in order to conduct the analysis.  The other side of that coin, however, is that you have to do all the work.  Just kidding, Bob.  And thank you for your penetrating insights.
[Author’s note: Minyanville readers with a desire to delve into the weighty topics of money theory, inflation, central banking—along with a fascinating historical context and explanation of the math involved—have a golden opportunity to enhance their understanding by reading my friend Bob Eramo’s piece analyzing the dramatic changes that occurred during the Carter Administration in the late 1970s, when Paul Volcker was appointed Fed Chairman during a period of serious inflation and the Fed literally turned the financial system upside-down by switching from interest-rate to money-supply targeting.  Bob presented this paper to the Casualty Actuarial Society—“Money, Credit and Federal Reserve Policy Changes”—where it remains archived on their site.  Bob is also a member of the American Academy of Actuaries.  He currently serves on the American Academy’s Task Force on Emerging Issues. He has been Chief Actuary at a west coast insurer and also the Chief Actuary at a major insurance broker.  Currently he is providing input on the effect of the European economic crisis on the property casualty insurance industry.]
As the Obama Administration likes to say, Forward!  Here’s what we were able to glean from data off the Fed’s site:

The Money Data

M1 and M2 are the principal measures of money in our economy.  We are looking at almost six years of data in the following:

Since the beginning of 2007, the growth rates for these two measures, both seasonally adjusted and not seasonally adjusted, are shown below, in successively shortening periodicities:

As can be seen from the above, in every measure, the growth rates for 2012 are down significantly 2012 vs. 2011.  The “big bulge” rates evident in the periodicities since 2010-2011 are clearly in the past, and all of the current rates of growth are below since-2007-2009 levels too. Reserve Bank Credit

This one’s a stunner.  While it’s true we had a massive injection during mid- to late-2008, we have actually moved into negative territory recently.

And, finally, the complicated and rather esoteric stuff

It’s only since mid-summer 2009 the Fed has been active in the mortgage-backed and related derivatives markets, accumulating those things on its balance sheet.  That’s why I've left the time line the same as with the above, so you can see the large “blank” period when they weren’t doing anything.

Is the Carry Trade Finally Giving Way to Commercial Lending Activity?

Two Levels of Conclusions

There are two levels of conclusions to be drawn, as we see it.  The first is that money growth is not advancing as wildly as many commentators have pronounced or assumed.  This has a host of implications.  Probably the most important of these is even less prospect for Fed tightening than has been previously imagined, even though overtly and repeatedly stated by Dr. Bernanke.
The second level is a little more speculative and has to do with the rapidly approaching “fiscal cliff.”  Some are estimating as much as a 3.9 percentage-point reduction in the growth rate of GDP next year—enough to make the year’s total growth rate negative, plunging the country back into recession—should legislators fail to agree on something that will otherwise result in a combination of both large tax increases and government spending cuts. 

Not as much discussed is the successive phase of that event, yet another looming debt-ceiling negotiation, as our debt even now soars past $16.25 trillion.  All of this is further complicated by simultaneous effectuation of new Obamacare mandates and costs.  The combination of these rapid-fire developments in “perfect storm”-like conjunction cannot be viewed as positive regarding the already gloomy 8% or thereabouts unemployment rate, which in itself is understating true unemployment by two to three percentage points or more given reductions in the portion of that calculation related to workers who have given up looking for work (although that quantity may be stabilizing to some extent lately).
Oddly, given the convergence of all of these significant factors, it is quite possible—completely contrary to prevailing viewpoints—the Fed’s actions may have been too restrictive.  And that still leaves the unknown and highly unpredictable effects of further credit-rating-agency downgrades amidst this entire process, which in the past seem to have been fleeting in their market effects. 

We believe there is the possibility we may even have a “soft landing,” but that doesn’t mean the crosswinds approaching the runway won’t be without some turbulence.  If during this time frame the congress manages to come together on a plan for spending and tax reform—even if that includes a protracted government shutdown—we could resume the trajectory of slow economic growth we’ve been on for some time, with probable implications of flattening unemployment-rate trends at about the levels we’re experiencing now.
No positions in stocks mentioned.