Markets Sink, Fed in a Bind

Markets reacted negatively on Wednesday, June 19, 2013, after the FOMC released its latest statement and Bernanke spoke.  There was an indication that the Fed might start to reduce its rate of monetary inflation towards the end of the year.  Since the stock market has been juiced up by the Fed, it also sinks when the Fed gives a sign that it might be pulling back.

It was the following day that markets turned really sour.  Almost everything was hit bad.  The Dow was down well over 300 points, after having already suffered big losses the day before.  Gold was down as much as $100 and closed the week under $1,300.  And bonds really took a hit too.

Perhaps the bonds might be the biggest story out of this.  The 10-year yield ended the week over 2.5%. While this is still historically low, it is vastly higher from the rates we saw just a couple of months ago.  This is driving mortgage rates higher as well.

I continue to maintain that we are not going to see a huge spike in interest rates without seeing a rise in consumer price inflation.  The bonds fell and rates increased on fears that the Fed will be buying less government debt.  This is logical.  But it is important to think through the different scenarios with bonds and interest rates.

If the economy falls into recession or depression, then rates are not likely to go higher, unless it is accompanied by higher inflation.  Recessions tend to bring rates down as people look for safety for their investments.  In addition, if the economy goes into a deep recession and price inflation remains low, then it is likely that the Fed will jump back into action and create more new money.  This means more bond buying, which will bid up prices and bid down interest rates.  So while it is not surprising to see rates come off their near all-time lows, they are still really low by historical standards.

This whole thing is playing out at a seemingly slower pace than what we have seen in Japan.  In Japan, the central bank started inflating like crazy and the stock market there went crazy.  But then, within 6 months, it started having huge down days.  When the stock market is built up because of central bank monetary inflation, it doesn't take much to spook the markets and reverse the trend.

The scary part about this whole thing is that the Fed is currently monetizing debt at a pace of $85 billion per month.  That is about $1 trillion in a year.  The monetary base was only at about $800 billion back in early 2008.  The Fed has quadrupled the monetary base since then, and yet it still isn't enough to even give an illusion that things are getting better.  If the current "quantitative easing" isn't enough to keep things going, then the Fed really is in a bind.  It will either have to up the ante again or let a deep recession happen.  It will try to walk a tightrope between the two, but it can only last for so long.

The Austrian Business Cycle Theory is reality.  When the central bank creates monetary inflation, it misallocates resources.  Those resources have to be realigned to more productive uses in accordance with consumer demand.  For this to occur, there has to be a correction.  The central bank can continue to increase its rate of monetary inflation to keep the game going a little longer.  But at some point, we either see massive price inflation or the central bank has to cut back and we get a recession.  Sometimes we can even see massive price inflation with a recession.

The central bank doesn't have to stop monetary inflation.  If it just reduces the rate, this can be enough to start the correction process, even though the central bank's continuing inflation will prevent a full correction from taking place.

It is not being pessimistic to point out that a correction must occur.  It is realistic.  It is the consequence of the previous mistakes.  The Fed shouldn't continue to exacerbate its mistakes.  I really don't think Bernanke and company know what to do.  They are stuck.  Bernanke will be glad to retire.