LOOKS, SOUNDS AND SMELLS SAME

It's a long read but one worth it if you seek to understand the Fed and its inner workings.

You also get a glimpse of its expansionary financial muscles at work. The author tactfully uses the term aggrandizement. The Fed is like that giant sucking sound we've all heard about, sucking up more and more financial terrain in its growing regulatory efforts to be all in one and one in all.

Here are some excerpts.

In recent quarters, I’ve remained adamant that the immediate first step of the Federal Reserve in normalizing monetary policy should have been to reduce the size of its balance sheet. The Fed’s failure to prioritize that first step, in the apparent desire to maintain an aggrandized role in the U.S. financial markets, has significantly increased the risk of a collapse from the speculative extremes the Fed has created in recent years. Given the increasing risk-aversion evident in market internals, we doubt that even a reversal of last week’s rate hike would materially reduce that prospect.

To see why, it’s important to understand how the Federal Reserve’s tools - open market purchases, interest on reserves, and reverse repurchases - actually work in affecting the economy and the behavior of speculative investors.

Let’s begin with open market operations. Traditionally, the Fed has used open market purchases of Treasury securities in order to affect short term interest rates. The Fed’s transactions don’t really accomplish this by directly pressuring market prices higher and lower. Instead, the Fed has traditionally determined the level of short-term interest rates by determining the quantity of zero-interest money that must be held across the economy as a whole.

Specifically, when the Fed goes out and buys a Treasury bond from the public, it pays for that bond in the form of currency and bank reserves (known as “base money” or “monetary base”). The bond becomes an asset on the Fed’s balance sheet, and the base money is a liability of the Fed. As a reminder that currency is a liability of the Fed, look at one of the pieces of paper in your wallet that reads “Federal Reserve Note.” The same is true for bank reserves. Bank reserves are deposits that banks have with the Federal Reserve. They are assets to the banks, and liabilities to the Fed.

In short, when the Fed makes open market purchases of government bonds, it takes those bonds on as assets, and creates new liabilities in the form of currency and bank reserves.
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Moreover, as we should have learned from the global financial crisis, when the Fed holds interest rates down for so long that investors begin reaching for yield by speculating in the financial markets and making low-quality loans, the entire financial system becomes dangerously prone to future crises. If the Fed's mandate is really to support long-runemployment and price stability, the first priority of Congress should be to rein in this cycle of activist Fed intervention; to end the Fed's ability to promote yield-seeking speculation and malinvestment that only produces inevitable crises and weakens long-run U.S. economic prospects.

 The fact is that a quarter-point hike comes too late to avert the consequences of years of speculation, and while the hike itself will have little economic effect, the timing is ironic because a recession is already likely. The main effect of a rate hike will be to add volatility to an already speculative and now increasingly risk-averse market. The Fed’s real policy error, as it was during the housing bubble, was to hold interest rates so low for so long in the first place, encouraging years of yield-seeking speculation and malinvestment by doing so.
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advisorperspectives.com/commentaries/20151214-hussman-funds-deja-vu-the-fed-s-real-policy-error-was-to-encourage-years-of-speculation