Tuesday, September 17, 2013

The Fed's Double-Bind

The Fed will blow up the economy if it continues money-pumping, but it will choke off the fragile recovery if it cuts back its money-pumping.

The Federal Reserve is in a classic double-bind: as its policies to boost growth bear fruit, interest rates rise, threatening the very recovery the Fed has lavished trillions of dollars of quantitative easing (QE) to generate.

Higher growth naturally leads to higher interest rates, which then choke off growth.

The Fed's goal was a self-sustaining recovery, in which growth reaches "escape velocity," i.e. is strong enough to support higher interest rates.

But the pursuit of that goal via trillions of dollars of asset purchases has inflated asset bubbles in stocks and real estate. The Fed's goal was to push speculative and institutional money into risk assets such as stocks, generating a "wealth effect" that was supposed to spill over into the real economy via higher borrowing and spending.

The pursuit of "the wealth effect" via inflating asset bubbles has created another double-bind: now that markets have become dependent on Fed money and liquidity pumping, the Fed cannot reduce its QE money-pump (currently $1 trillion a year) without tipping the stock market into free-fall.

If the Fed continues its massive monetary easing programs, asset bubbles will only inflate to speculative extremes, to the point where violent bursting becomes a matter not of "if" but of "when." (This is also known as "the music stopping.")

If the Fed cuts back its money-pumping and asset purchases, interest rates will rise, as interest rates will seek a market level that isn't pushed to near-zero by the Fed's financial repression.

Higher rates will choke off tepid Fed-induced growth. We already see home refinancing rates plummeting to 2009 recessionary levels.

So the Fed risks blowing asset bubbles that will devastate the economy if it continues the QE pumping, but it risks killing the tepid recovery if it cuts back its pumping. Darned if you do, darned if you don't.

Put another way: if growth is needed to boost corporate sales and profits, but growth leads to higher interest rates and reduced central-bank suppport of markets, this is a double-bind with no exit.


Note: blog entries and email will be sporadic for the next few weeks. Your patience and understanding are greatly appreciated.


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