Monday, May 4, 2015

The Federal Reserve: In Unchartered Territory

'Let me see if I fully understand QE3
and the Federal Reserve expanded
balance sheet..'-Sir Isaac Newton
We had the occasion recently to catch up with a recent college graduate friend of ours (we have trained hundreds now in The Institute for the Public Trust) who is now in the last year of his Ph.D program in statistical economics, whatever that is.

He is a gifted advanced mathematics person with a great sense of humor and interpersonal skills, which is rare for most statisticians and economists we have met over the years, truth be told.

Economics is the 'dismal science', you know, as coined by Thomas Carlyle in 1849. Many economists we heard in testimony on Capitol Hill sounded more like mortuary owners to be honest about it. They have predicted 10 of the last 3 recessions goes the old saying so they come by their characterizations naturally.

We asked him what he was doing and he said he was going to work for the Federal Reserve this summer. Not bad for a bright young recent college grad to be working at one of the most important and powerful quasi-government agencies.

He is interested in markets and since the Fed is where all the transactions are made for the issuance of new America debt, they have asked him to come in and do some research on how these markets are behaving now. Which stands to good reason since, as we have written about many times now, there always comes a time in any nation's economy where too much debt issued starts to cause a major problem for the host country and the time to head those problems off is way ahead of that day of reckoning, not after the collapse of the currency has started to happen.

So far, so good. We always want to see and encourage bright young people to enter public service on the behalf of the rest of us, simply because that is what our Founders did by example as a model they wished for the rest of us to follow.

So we asked him if any of his internship would cover any of the 'expansion of the Fed balance sheet' we have heard so much about and in a brief flurry of comments, this is what he said:

'The people I have interviewed with say that we are in uncharted territory in this regard and we have never done anything like this before in American history. They say there is really a great degree of uncertainty about what the right plan of action is to reduce this expanded balance sheet.'

'So they are asking you to come in and help them, is that what I am hearing?' I had to inquire.

'Well, yes. Sorta. Yeah, mostly. They are hoping for a fresh perspective on things' he said.

'You know, I know you are a smart young feller and all that. But if the US Federal Reserve is bringing in fresh young Ph.D doctoral candidates, especially ones I know and like and whom I know spent a whole lotta time drinking beers (at Players, Players Retreat, He's Not Here, Mitch's Tavern, take your pick) during their undergrad days, that doesn't give me a whole lotta confidence that this is going to end well!' I told him honestly.

That is like that old saw you used to hear when people would say the scariest moment in your life will be if you are wheeled into an emergency room and the doctor takes off his mask before performing surgery on you and he says: 'There ya go now. Don't worry about anything. It is me, Sharky. Your fraternity brother from college. Just leave everything to me' as you drift off into an anesthetic state remembering all the crazy things he did at the fraternity house during his four years there.

Here's something not many mere mortals on earth have ever read, much less ever known about or heard talked about: The Balance Sheet of the US Federal ReserveGo ahead; read it and see if you can make any sense of it on the first reading.

We are not going to even fake trying to understand all the intricacies and cash flows of the Fed in this short of amount of time. We have spent 5 years and close to 600 posts so far trying to boil down the intricacies and confusion of the US federal budget to an essential gruel that can be ingested by most people and understood over time and the Fed is just a horse of a very different color we believe.

Take a look at this chart though if you want to see how alarming the 'expanded balance sheet of the Fed has become in a very short amount of time:

From the onset of the Great Recession in 2009 to today, the Fed Balance Sheet expanded from a historical 'normal' rate of about 6% of GDP to almost 20% of GDP in a very short amount of time. Current estimates of the expanded balance sheet are about $4 trillion.

What does this mean for you, the average Joe Citizen of America?

Not much. Unless you consider the fact that finding the exactly right solution is akin to Tom Brady throwing a football the length of the field and threading the needle through the out-stretched arms of 3 tall cornerback defenders into the safe arms of one of those short Patriot receivers in the corner of the endzone in the last second to win the Super Bowl.

It 'can' be done. But the chances of it being done perfectly is very, very slim indeed.

We'll try to find some more explanation on reducing the Fed's balance sheet and try to parse this out some more since it will affect us all one way or the other. Countries that have tried to 'expand their balance sheet' and 'expand their money supply' to avoid some current economic crisis have inevitably awakened the inflation demons in the past so don't get too comfortable with the next-to-zero inflation and interest rate environment we have been stuck in the last 6 years.

Some European nations have gone so far as to issue 'negative interest rate' bond instruments meaning you give them $1000 of your money to hold in safe-keeping...and you get back $975 of it after some specified length of time. Think about that for a moment if you think we are in 'normal' economic times.

So keep in mind the comments of our young friend as you go about your day. We hope he is a savant on the order of magnitude of an Isaac Newton who, in the very brief span of 18 months in his young life on a relative's farm from 1665-1667 where he was sent to avoid the scourge of the Black Plague in London at the time, discovered the basic principles of calculus, optics and gravity. In less than 18 months.

Our young friend is going to need that same supernova explosion of new ideas to grapple with the Fed's expanded balance sheet and how to get us through it without igniting the fires of inflation that have accompanied every other expansion of money in history.

'Godspeed, John Glenn' is all we can say.

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