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Minyan Mailbag: Fed's Fix


Banking problems will yield to deflation.

Mr. Practical,

I hope this note finds you and your family well. I have always enjoyed your commentary as it requires more than just a cursory glance and forces you to think. While I have found your deflationary case compelling, at times I still found myself questioning your argument.

However, I certainly have had a change of heart as I see first hand the massive removal of liquidity from the financial system by large institutions like Citi (C) and the contraction that we experienced in the asset back CP market and most recently in the auction rate securities market. I recently came across a report that unequivocally details evidence of the Fed's activity in removing liquidity from the markets. Many pundits/analysts have been making the case for extreme inflation through reconstructing M3 and pointing towards its rapid growth but the report that was recently issued by the NY Fed lays out just exactly what the Fed has been doing. Specifically, please look at the chart on pg 16 of this report (pg. 18 of the PDF version).

I would sincerely appreciate your thoughts on this specific chart and if you have time to read it, this report. In my mind, one no longer needs to make a case for a deflationary credit contraction (sorry gold bugs), as one would be hard pressed to dispute this report in light of current market activities by the large money center banks. I certainly wish for the contrary as the end game will not be pretty. I look forward to getting your feedback. Take care.

- Minyan Alan


The banking system and the relationship it has with central bank borrowing is not operating normally; one should not expect the Fed to operate or communicate in a normal fashion. We will be seeing various "nationalization" and "socialization" remedies over the next year that will be desperate and unconventional. You have to start thinking outside of the box to keep up with what the Fed is doing.

The issue you refer to is a close cousin to the non-borrowed reserves situation that has developed over the last few weeks where the TAF auction process has made up for or replaced the usual repo market as a source for bank overnight and short-term funding. The attached chart shows a precipitous drop in SOMA (short-term money market operations) and REPOs all but replaced with the TAF and the currency swaps that were drawn by the ECB and the Swiss National Bank so that the overall levels of the Fed's domestic portfolio remain largely unchanged.

Click to enlarge

What has changed is the composition of the portfolio, not how much the Fed is creating liquidity in the system, as it were. It doesn't really have the ability to create liquidity. Only the market and the banking system can do that.

But the banking system is broken so the Fed is going to very unusual lengths, such as TAF auctions and, I suspect, continuous rollovers (thus not increasing the size of balance sheets when you take a snapshot, but in the shadows is massively increasing risk to the Fed) to try to keep the banking system afloat by lending it money that we don't see on its balance sheet.

Of course, none of this ultimately will affect the larger deflationary credit contraction picture: As the senior loan officer survey last week illustrated very clearly, the debt deflation is occurring outside of the Fed's control at the world's money center banks, where supply and demand for credit has undergone a rapid and significant decline. The asset-backed commercial paper market was the first such market to experience this shift back in August; the $300 billion term auction market (where the Port Authority's rate went from 4.5% to 20%) and even the municipal bond market disastrous auctions are but the latest examples.

They won't be the last. I didn't answer a Minyan who asked where this all ultimately leads. I don't have the answer to that, but have described the conditions that exist, ones that have never before existed. The world will finally face in some fashion a wave of deflation over the next several years.

Deflation will be ugly but it has some ultimately good results. It wipes out debt (which is painful), but ultimately realigns the world's economies for future growth: it will over time re-distribute wealth from the rich to the poor (which is why those in power hate it so much and love inflation).

To deal with it be out of debt and be patient.

- Mr. Practical

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