PART ONE - STEP ON THE GAS!

I have been sent several email questions over the last month about inflation and deflation and why our Federal Reserve would "print" all of this money. This blog entry may be a bit long (I've had to break it into two parts), but I feel it is important that we all understand the motivations of the players (central banks) in this economic turmoil. For an introduction into how the Fed and administrations have acted, please review the first four paragraphs in the blog back in August where I discuss asset bubbles created by cheap money in Proof that this Recovery Has Been Engineered.



IT ALL COMES DOWN CREDIT.

Let's quickly review a description of inflation and deflation. While most of us think inflation is a measure of rising prices, it really is a measure of an expansion of the money supply and credit. Once a bank lends you money, you can spend it or invest it as you please. Because banks only need to maintain about 1/10 of the dollars deposited with them in their reserves, we get significant growth and expansion of available money when banks actually lend. Think about it. When a company or account holder deposits $1,000,000 in a bank, the bank can then lend out $900,000 of that same money to someone else. If that borrower then deposits that same $900,000 in an account, the bank can lend out $810,000 to another borrower. Do that over and over again and you see the impact of the original $1,000,000. Fractional reserve lending is very stimulative and pushes significant dollars into the economy.



Once those dollars enter the economy through creation new money supply and credit, they tend to find assets like houses, cars, commodities, commercial real estate. These additional dollars often burn a hole in people's pockets and this extra demand allows retailers and suppliers to raise prices. This is how we often believe that inflation is the same as pricing increases.



Well, that's easy enough to understand right? When folks borrow from banks to build a house, add a pool, or create a business they trade those dollars for a service and the recipient of those dollars deposits that same cash in their bank account and the magic money creation machine keeps churning out opportunity for all. This scenario is in fact exactly what happened for years in 1996 to 2001 and then from 2003 to 2007. Keep one other thing in the back of your mind. fractional reserve lending requires the guy that borrows the money to spend it and repay it. In fact if your thought is that it sounds a lot like a ponzi scheme, guess what, you are right!



PLANET REALITY

If this situation is so good, what could be the problem with all of this lending and borrowing? Nothing really, unless you complicate this scenario with something called "reality". In real life, banks are often required to examine the credit worthiness of borrowers. The bank loan officer takes into consideration if the borrower has a job, has good credit history, and also if they have any assets. Finally, a good loan officer examines this picture of the borrower and should demand a suitable rate of interest for the loan. If a potential borrower has good collateral, a great project, awesome credit history and is well capitalized, they should be charged a lower interest rate for the amount they desire to borrow as compared to a riskier prospect. In fact, riskier borrowers should be charged significantly higher rates or be declined. So one of the first things a lender must evaluate is the ability of a borrower to repay the loan and the appropriate price for that loan.



Ok, sounds good. What could possibly go wrong? To save time I'll just bullet point these next items and then make just a few comments.

• Mispricing of risk at the lender level - What if the loan officer has a bad day and he doesn't notice that the borrower has poor credit history. This error can result in charging too low of a rate for the loan. Other issues could be that the collateral of the loan was in bad condition or the borrower didn't make enough income to justify the amount requested. This mispricing of risk could be detrimental to the bank as they don't get paid enough for the risk they take or take on a loan that will ultimately default.


• People lie - Imagine that people in this process didn't tell the truth! If the lender didn't take the time to verify an applicants income or credit history, the integrity of the entire process could be in jeopardy. In recent times, lenders gave loans to people with "stated incomes" meaning that they simply said an amount that they made.


• People lose their ability to repay their loans - In the current economy we can easily see that a borrower could lose their job. If an applicant loses their ability to pay, often they cannot keep their homes.


• Collateral values decline - In recent history from 1996 to 2007, home prices and other asset values always rose. One of the problems in lending evaluation methods was to assume that prices would not drop. Unfortunately we've realized that prices of homes and collateral can drop and may do so all at once over large regions of our country.
• Government Intervention - We also had a situation where the government told lenders that they needed to lend in certain regions of cities and states. Typically these were areas where borrowers were less credit worthy
  

ARE THERE ANY OTHER PROBLEMS INVOLVING CREDIT THAT WE'VE FAILED TO DISCUSS?

Of course! When we borrow using our credit cards from banks we usually have our loans tied to some benchmark rate. You've heard of LIBOR (London Inter-Bank Offer Rate). This is the interest rate that one bank will lend to another. When you borrower, you generally must pay the LIBOR rate plus some percentage rate. Other benchmarks could be the 10 Year Treasury Note rate. These benchmark rates are important because central banks can control or direct the price of these rates. Our Federal Reserve sets the overnight bank lending rate called the Fed Funds rate. By raising and lowering this rate, the Federal Reserve can influence interest rate costs globally. Yes, some will argue that these are overnight funding rates, but the reality is that the Fed Funds rate does have an impact on other credit interest rates in the market.

What would happen if the Federal Reserve significantly lowered the Fed Funds rate? The impact of a lowered Fed Funds rate would be that other rates would fall as well. From this simple example you can see that the Federal Reserve has some ability to change interest rates and in this scenario lower borrowing costs for banks, companies, and borrowers.

WHY IS THE FED'S INFLUENCE A PROBLEM?

A central bank's role is a tough one (in the USA at least). They must try to create a perfect balance between growth and recession. The Fed uses its control over the Fed Funds Rate to stimulate and restrain the economy (think of it as an accelerator pedal on a car). As we covered earlier, when rates are low, people are incented to borrow. Their borrowing is used for investment and an expansion of the economy often results in pricing increases due to the availability of ample credit. When the Fed over does the credit available, borrowers are flush with cheap money and they tend to buy everything in sight and prices result. Using this concept of mispricing, we can therefore see that when the "Fed over does it", it really has mispriced rates and created too much demand and too much easy money!

If you are a banker you are subject to pricing your loans off of a benchmark rate. If a potential borrower barely qualifies for a loan you examine rates of your benchmark and add a premium or mark up over that rate based on their credit. The real issue here is that if the Federal Reserve has driven rates lower during this period, (artificially controlled them and pushed them lower), then the banker has really priced his loan too low for this borrower. The impact of the Fed's decision to make cheap credit flow is that they have heaped on additional risk into the banking system in an effort to expand the economy.

Perfect, what happens when the Federal Reserve raises rates? Just like taking the foot off of a gas pedal, raising the Fed Funds rate cools off the economy by removing additional credit stimulus. Rates go higher and investors and borrowers costs rise. Imagine if you were going to build a pipeline or factory. Increased borrowing costs negatively impact your rate of return and make investments and projects seem less appealing than when rates were low.



ARE THERE RECENT EXAMPLES OF THE FED MAKING CREDIT AVAILABLE THROUGH THESE TECHNIQUES? WHAT WAS THE RESULT?

Absolutely. Recall the fears that all computers would crash as a result of the Y2K bug in 1999. (When computers were going to switch to the year 2000. Many computers tracked dates with only 2 digits before this). The Fed responded by flooding the market with liquidity (lower rates and buying treasury bonds). As the market was awash with credit and money, guess what happened? All of that money found its way into our technology sector and the internet mania began!



As the Fed began raising rates after Y2K, we suffered the bursting of the internet bubble.



After the tech crash and the September 11th attacks the Fed again began lowering rates to fight the economy's recession. What happened next? Credit found its way into the hands of real estate investors and speculators. The ingredients of a new real estate bubble were combined and areas in Nevada, Arizona, and California enjoyed 100% growth in real estate prices in the course of one or two years. Clearly the free flow of credit as a result of low rates bought us a ticket to Planet Credit Fantasy. As the good times were rolling, the Fed began to raise interest rates in an attempt to manage price inflation in 2003 and continued to slow the economy through 2006.



HAS THE FEDERAL RESERVE BEEN GOOD IN ITS ABILITY TO TIME ITS RATE DECISIONS?

Unfortunately, the answer is flatly no. Typically the Fed's tools like Fed Fund rate changes and open market operations are slow working. The influencing mechanisms work through the economy and are difficult to start up and stop. Many often use the analogy of trying to turn an oil tanker when describing the amount of control the Fed has in making adjustments to the economy. I'm highlighting this because we have had very low rates for a significant amount of time. As our credit bubble burst in late 2007 and early 2008, the FED stomped on the accelerator and eventually lowered the Fed Funds rates to .25%.



So to wrap this up, we entered a credit led bubble in 2003 that artificially created a real estate blow up waiting to happen. Credit lenders mispriced risk and the Fed purposefully mispriced risk to stimulate the economy. As the wheels were coming off beginning in August of 2007 we faced many "unforeseen" circumstances.

1) A recession was forming and people were losing their jobs
2) Because folks were out of work, they were not making their home payments.
3) As payments were missed, banks began foreclosing on homes in record numbers.
4) Investors and lenders began to understand that home prices don't typically go up every year.
5) People began to doubt each other. Banks failed and lenders tightened up lending standards considerably.
6) The Fed reacts to the collapse of Bear Stearns and Lehman Brothers (securitization of mortgages) and takes FF rates from 1.50% to .25% in two months.
7) Congress passed the $700 Billion TARP funds bailout and other scandals. They end up adding trillions to your debt and you don't even know it. Your debt is used to keep failed banks alive and prevent write downs and destruction of credit...... in other words, your balance sheet and future income was used to stave of DEFLATION, which is the destruction of credit.



WAIT A MINUTE! LET ME GET THIS STRAIGHT!
Ok, so you say that the Fed helped create this mess by lowering rates and now their response to this crisis is to what? LOWER RATES!!! You got it! When you are a hammer, everything looks like a nail. Each crisis the Federal Reserve is involved in will evoke the same reaction, lower rates!

Ok, why would the Fed do this if it knows that another bubble will form? The real question is what will we find if another bubble is NOT formed.

Presently, the Federal Reserve has been able to lower the cost of a 30 year mortgage to 5% for a borrower with good credit! A 30 year US government bond is paying only 4.16%! This is even cheaper than when we were in the throws of the real estate boom. Why are cheap rates essential? Our leaders have just told us if we can stabilize real estate prices that will bolster demand for furnishings, dishwashers, cars, and more. In other words, in the eyes of your government, if you perceive that your house value is not dropping you'll get out there and spend more than you have and put it on credit cards and you will save the economy. It is staggering that 70% of our annual GDP is comprised of us buying stuff rather than production and manufacturing stuff in the USA. Now you can understand that if there is a situation where Americans don't spend, the economy of the USA grinds to a halt.

In the next post we'll cover what deflation looks like and what the Federal Reserve plans to do about it.

Also, a quick thank you to Michael Shedlock for his comments on this post and the clarification he suggested. You can read his views on the broad economy here. He has the number one financial blog in the world with over 28,000,000 visits to his site and I believe that he is a must read daily. I frankly am flattered that he commented on this post.

http://globaleconomicanalysis.blogspot.com/