Prechter: Why the Fed Will Not Stop Deflation
Editor's note: Robert Prechter's Latest Elliott Wave Theorist [1] was released three weeks early, and is one of his best Theorist's ever. He does not mince words and cuts straight to the bone on what theFed is and is not willing to do. It is fascinating reading. I havearranged to make this brief excerpt available.
Excerpted from The Latest Elliott Wave Theorist [2]
August 26, 2007 | Robert Prechter
Reprinted with permission
We hear it every day: "What about the Fed?" The vast majority ofinvestors and commentators seem confident that the Fed's machinationsmake a stock market collapse impossible. Every hour or so one can reador hear another comment along these lines: "the Fed will provideliquidity," "the Fed is injecting money into the system," "the Fed willbe forced to bail out homeowners, homebuilders, mortgage companies andbanks," "the Fed has no choice but to inflate," "the government cannotallow deflation," "the Fed will print money to stave off deflation" andany number of like statements.
None of them is true.
The Fed is not forced to do anything; the Fed has not been injectingmoney; the Fed does have choices; the government does not controldeflationary forces; and the Fed will not print money unless and untilit changes its long-standing policies and decides to destroy itself.
A perfect example of one of these fallacies recently exposed is thewidespread report in August that the Fed had "injected" billions ofdollars worth of "money" into the "system" by "buying" "sub-primemortgages."
In fact, all it did was offer to stave off the immediate illegality of many banks' operations by lending money against the collateral of guaranteed mortgages, but only temporarilyunder contracts that oblige the banks to buy them back within 1 to 30days. The typical duration is 3 days. Observe three important things:
- The Fed did not give out money; it offered a temporary, collateralized loan.
- The Fed did not inject liquidity; it offered it.
- The Fed did not lend against worthless sub-prime mortgages; it lent against valuablemortgages issued by Fannie Mae (the Federal National MortgageAssociation), Ginnie Mae (the Government National Mortgage Association)and Freddie Mac (the Federal Home Loan Mortgage Corporation). The NewYork Fed is also accepting "investment quality" commercial paper, whichmeans highly liquid, valuable IOUs, not junk
As a result:
- The Fed took almost no risk in the transactions.
- The net liquidity it provided -- after the repo agreements close -- is zero.
- The financial system is still choking on bad loans.
- Banks and other lending institutions must sell other assets to raise cash to buy back their mortgages from the Fed.
These points are crucial to a proper understanding of the situation.The Fed is doing nothing akin to what most of the media claims; likeMcDonald's, it is selling not so much sustenance as time, in this casetime for banks to divest themselves of some assets. But in the Fed'scase, that's all it's selling; you don't get any food in the bargain.
As I have said before, the Fed is a bank. It has private owners. Theowners do not want to see their enterprise destroyed. Although Bernankeprobably received distress calls from mortgage lenders, he probablyalso got calls from the Fed's owners saying, "Don't you darebuy any of that crap and put it in our long-term portfolio." The Fed'sowners are smart. They exploit the banking system without taking on anyof the risks. They let member banks make mortgages and lend toconsumers, but they don't do so themselves.
In the early 1930s, as markets fell and the economy collapsed, theFed offered loans only on the most pristine debt. Its standards havefallen a bit, but not by much. Today it will still lend only on highlyreliable IOUs, not junk. And it doesn't even want to own most of those;it takes them on only temporarily as part of a short-term repurchaseagreement.
The Fed's power derives from the value of its holdings, which areprimarily Treasury bonds, which provide backing for the value of theFed's notes. What would a Federal Reserve Note be worth if it werebacked by sub-prime mortgages? The real value of U.S. Treasury debt isprecarious enough as it is, but at least it has the taxing power of thegovernment behind it. But if the Fed bought up the entire supply ofsub-prime mortgages, its notes would lose value accordingly. So willthe Fed bail out mortgage companies, as the optimists seem to think?No, it won't. Those who think the Fed will buy up junk with cashdelivered by helicopter are dreaming.
Ironically, of course, the Federal Reserve System and the federalgovernment-both directly and via creations such as privileged mortgagecompanies and the FDIC-have fostered all the lending and thejunk debt that resulted. But these entities want only to benefit fromthe process, not suffer from it. As we will see throughout the bearmarket and into the depression, the Fed is self-interested and will notbrook losses in its portfolio. Those who own the bad loans, and perhapssome foolish government entities that try to "save" them, will takelosses, but the Fed won't. ...
What must the banks do with their "grace period" of a few days that the Fed's repo agreements provide? They have to raise the cash to buy back the IOUs that the Fed agreed to hold for them.How does a bank raise money? By selling assets. Thus begins thedownward spiral: Contracting credit causes asset sales, which causecollateral values to fall, which causes lenders to curtail lending,thus contracting overall credit, which causes assets sales, and so itgoes. Thus, the Fed is not staving off deflation; at best, it may havehelped -- momentarily -- to make it more orderly. But the selling ofassets has begun regardless.
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More follows for subscribers. The complete issue totals nine pages, including: [3]
- The Fed Is Not Smart Enough to Stop Deflation, Even If It Could
- A Deflationary Spiral
- The Home Investment Illusion
- Economic Contraction Approaching
- A Profit in Losses
