More on bonds, interest rates, and the Fed

Last Sunday I wrote about serious problems building up in the bond market.  Two days ago I followed that article with a more in-depth examination of why rising bond interest rates were going to affect the entire economy, not only of this country, but of the world.

My points have been confirmed and reinforced by reports from two different sources.

First, PBS addressed the situation in three articles this week:

• The Fed's Terminal Dilemma: When to Begin 'the Great Unwind'
• Art Laffer, John Taylor, Simon Johnson Respond to the Fed's 'Great Unwind' Problem
• Is the Fed's 'Great Unwind' a Nonevent or the Chickens Finally Coming Home to Roost?

This series of articles is extremely unusual, as PBS has tended to follow along with the rest of the mainstream media and ignore many of the problems in our economy.  If even PBS is now sitting up and taking notice, you may be sure the problem's gotten a whole lot more severe than its reporters and economists had anticipated - so much so that they can no longer afford to ignore it.  Its conclusions are dismissive of the problem, to be sure - but it voices contrary opinions, and allows them to be heard.  Needless to say, I don't agree with PBS's conclusions!

Of particular importance is this graph, cited in the first article linked above.  It's from the Federal Reserve Bank of Cleveland, and is titled 'Credit Easing Policy Tools'.  The small version below doesn't do it justice, and is almost unreadable.  Click on the link above, or on the graphic below, to go to its source page and view it at full resolution, along with an explanation of what it means.

From the PBS article, referring to this graph:

The chart reflects that early in 2007, before the crisis, the Fed held $860 billion in assets. You can see, as you follow it to the right, that the Fed's portfolio has grown to over $3.4 trillion today. In other words, the Fed has quadrupled in size ...

What will happen if, in order to forestall inflationary pressures, the Fed needs to reverse course and, over a short period of time, sell a meaningful part of the trillions in bonds it has bought? As Buffett intimates, it would be ugly: interest rates would spike, and this could pull the stock market down sharply. We had a hint of that kind of market decline already. In June, the Fed suggested that it would start to taper off new bond purchases within several months, which means buying less, not actually selling, and this led to a temporary dip in stock prices and a rise in interest rates.

Because the effect on markets would be so negative, it is a pretty safe bet that the bonds will stay where they are, i.e., on the Fed's balance sheet, as long as inflation stays low.

But will inflation always stay low? Maybe not. And the necessity of choosing between the risk of inflation, on the one hand, or knocking down markets, on the other other, is the dilemma ...

There's more at the link.  Note that the Fed now has on its books well over $2 trillion in Treasury securities, and in 'distressed' mortgages (mainly bought from Fannie Mae and Freddie Mac) or FHA loans.  Those burdens are now on the taxpayer's back.  They weren't there before this crisis . . . but we're all liable for them now.  Those debts have been 'monetized'.  Does that make you feel happy?  I thought not . . .

Next, Zero Hedge points out:

When federal spending grows faster than American's paychecks, the burden of government on taxpayers becomes greater. Over the past four decades, Americans' earnings have risen only 24%; while spending by the government has risen 288%, which begs the question - where did it all go?

Again, more at the link.

That graph illustrates precisely why the Treasury has to issue so many bonds, and why the Fed has to buy them to keep interest rates down (because outside investors - who can read the writing on the wall, thank you very much! - are no longer doing so).  The Federal government currently obtains close to half of every dollar it spends through debt and deficit finance.  It's spending vastly more than it takes in through taxation.  The above graph doesn't show business tax, of course, or customs imposts or other non-household sources of revenue, but what it does show is clear and accurate.

Government spending is the problem.  If it continues to run rampant, sooner or later we're going to go bankrupt.

That's the way it is.

Peter