Every once in a while I entertain the fantasy of being at the helm of the Federal Reserve. In a moment of megalomania I am proposing this solution to situation that the FED finds itself: The velocity of money is extremely low as zero interest rates have led to a massive buildup of overnight reserves at the FED. Money’s low velocity is compounded (pun intended) by the bloated balance sheet that the Fed has attained through its massive QE program. Certain voices are maintaining that the severe flattening of the yield curve is precluding domestic banks from making greater profits, which results in less lending activity. It is not only the low profits impeding bank lending but also the massive amount of high quality collateral controlled by the FED that diminishes financing activity from the shadow banking sector via the REPO market. IF THE FED WERE TO BEGIN SHRINKING ITS BALANCE SHEET BY SELLING TREASURIES OF A 10-YEAR OR LONGER DURATION, THE YIELD CURVE WOULD STEEPEN AND THE REPO MARKET WOULD SPRING TO LIFE AS MORE HIGH QUALITY COLLATERAL WOULD CIRCULATE IN THE MARKET.
The FED could shrink its balance sheet instead of adjusting the FED FUNDS rate. By holding down the short end the curve would steepen unless the current bout of flattening was genuinely a symptom of global growth fears. But at least we would get some clarity from market forces. Now I am aware that some will be concerned that such a move by the FED would drastically raise long rates as the market becomes flooded with U.S. sovereign debt. I say not so quick for the amount of FED selling could be tied to the amount of ECB buying: $90 billion a month. The ECB‘s willingness to increase its balance sheet provides the perfect stabilizing mechanism to offset the Fed’s need to contract its Treasury holdings. A possible negative effect will be a rise in the DOLLAR but even this outcome may be softened by investor purchases of European sovereign debt, and, of course, European equity as Europe will be deemed a more desirable investment opportunity. The FED WANTS to raise rates to secure a measure of flexibility in responding to the next economic slowdown. It seems that having room to maneuver in the use of LARGE SCALE ASSET PURCHASES is far better than playing with overnight interest rates in the land of the zero bound. The ECB is providing the perfect out for the FED. This is some of our thinking in the land of 2+2=5.
***Just a bit more clarity on Brexit. In a Financial Times article, “France Attacks UK Corporate Tax Plans,” it was reported that French Finance Minister Michel Sapin warned the U.K. that any attempt to secure a competitive advantage by cutting corporate taxes would be viewed by France and Germany as hostile and would sully future negotiations. (“France and Germany are both concerned that the UK will be tempted to establish itself as a low-tax offshore jurisdiction on the EU’s outskirts in response to the leave vote.”) Brussels will do all it can to ensure against Brexit resulting in a positive outcome for the UK. Because the global financial system failed to collapse in response to the LEAVE vote, the self-proclaimed pundits are striving to prove themselves correct and raise the barriers of obstruction on the European island. Also, to those who throw mud on the Brexiters by labeling narrow-minded old-timers unconcerned about the next generation I raise this question: Where are all the voices of concern about the destruction of the youth of Spain, Portugal, Greece, Italy and France who are continuing to experience DEPRESSION levels of unemployment for the under-25 age group? THE EURO CURRENCY HAS LED TO POLICIES OF INTERNAL DEVALUATION TO MEET AUSTERITY BUDGETS IMPOSED BY BRUSSELS, RESULTING IN the devastation of European youth. As Williams Jennings Bryan might say, a generation has been crucified on a D-Mark Cross.
European youth unemployment: Spain 43.9%; Greece 50.4%; Italy 36.9%; Portugal 28.6%; France 23.3%; and Great Britain 13.2%. Maybe the wake-up call from the British citizenry had more foresight than the pundits allowed. Now about those Italian banks…