The Battle of Evermore

I have been having a running battle with a colleague (financial adviser) regarding Fed policy. He states that the real reason the Fed has eased and why it should continue to ease is to save the banks by steepening the yield curve thereby enabling banks to borrow cheaply and profit from lending. Although my dear colleague would have been (simplistically) correct during the Greenspan years, he has not accepted the current reality. I fear that many of my readers may also be living in a fantasy world. Here is a splash of cold water to shock you all back to reality.

The Fed has indeed eased to help the banks, but not to help them generate profits via their lending businesses. The Fed has made a cornucopia of capital available to banks so that they may stave off catastrophic failures. Banks are not lending most of the capital they are raising. They are using it to offset writedowns, most of which will never be written up appreciably if at all, so as not to fail. This is about basic survival

Traditionally the Fed lowers rates to make capital affordable to spur consumer spending (homes, cars etc.). The result is usually somewhat inflationary which causes long-term rates to rise which makes the so-called carry trade (borrowing short-term and lending or investing long-term) profitable. The Fed would do a group cartwheel of it could pull this off now. Not only is this not happening now, it is not going to happen for quite some time.

The Fed wantsto tighten. It knows it needs to tighten, but it cannot as long as troubled banks threaten the viability of the U.S. financial system. The Fed and the Treasury Department have been working to find a way to get the banks off of the Fed nipple. Treasury Secretary Hank Paulson may have found a way. Rather than bail the banks out, create a moral hazard which encourages poorly thought-out risk taking (the function of Fed easing for every crisis), Mr. Paulson is working on a way to permit financial institutions fail in an orderly fashion.

Mr. Paulson suggests SWAT teams which would administer the asset sales of troubled financial institutions. The FDIC has a similar mechanism in place for commercial banks. This would apply to investment banks. This way the Fed can manage inflation and growth without screwing the remainder of the economy wiping up after imprudent investment bankers.

The sooner the Fed tightens, the sooner food and energy prices begin to stabilize and, hopefully, decline somewhat. Consumers, less burdened by higher food and energy prices, will begin spending in other areas of the economy, maybe even buying homes (when financing is available) and economic growth will resume. Imagine that, raising rates to promote growth. Seem like I have seen this before, eh Paul?