You can’t get something for nothing

The market seems to be absolutely focused on the Fed.

Everyone seems to think the Fed has the power to make or break the economy, get lending moving again, support the dollar, etc.

The fact is, the Fed doesn’t have that much power. If you don’t believe me, go read John Hussman’s article on the subject, or read any of his recent weekly commentaries that address the issue.

The thing that surprises me is how many people believe the Fed can take action with no seeming repercussions. As if the Fed could move interest rates, or lend money to banks without any adverse reaction.

The reality is that the Fed can only take action with consequences, just like the rest of us mortals.

When the Fed offers liquidity, they are printing money and creating inflation.

In the long run, the Fed doesn’t matter much, although they do have a short term psychological impact on the market.

Even worse than that, the Fed’s actions almost always come with some downside, and that long term impact can be profited from by smart investors.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Will the Fed cut rates?

The market certainly seems to think so.

Just look at interest rate futures and you’ll see investors are expecting a 25 to 50 basis point cut in the Fed Funds Rate.

Or, more meaningfully, look at the gold market. Gold prices spiked to over $785 an ounce, today.

That’s up 17% over the last month and 31% over the last year.

Why does the gold market indicate a cut in the Fed Funds Rate?

Because the Fed does not create growth–they do not possess some magical fairy dust that makes the economy run faster.

The Fed prints money to decrease interest rates. And, when the Fed prints money more quickly than the economy grows, they create inflation.

Gold prices are going up because gold investors believe the Fed will print money, also known as cutting the Fed Funds rate, thus creating inflation.

Gold is going up because investors are guessing the Fed will create inflation by cutting rates.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The Fed’s interest rate cut hurts the prudent

For those who think the Fed’s recent interest rate cut is an unmitigated good, read Allan Sloan’s recent Fortune article titled, “Heads I Win, Tails I Get Bailed Out; The reckless are getting relief from Bernanke. How does that work?”

I’ve blogged in the past about the moral hazard implicit in the Fed cutting rates. I believe the Fed’s large rate cut encourages imprudent risk taking.

But, I didn’t highlight how the rate cut hurts the prudent, and Allan Sloan does a great job of that. As Sloan puts it, the “recent interest rate cut has done a lot of harm to those of us who’ve managed our finances prudently.”

The Fed cut rates to calm market turbulence, and this was directed to helping the “players in the biggest trouble,” those “who’d taken the biggest fliers in junk mortgages, ultra-risky leveraged buyouts, and other financial esoterica that proved to be malignant.”

But, this rate cut not only helped the imprudent, it hurt the prudent. It hurt “those of us who keep score in dollars and didn’t need to be bailed out” because we are now “less wealthy than we were in terms of anything other than our home currency.”

Why? Because the rate cut “contributed heavily to the dollar’s recent sharp drop in the currency markets…and to the price spike in hard assets like gold, silver, copper, and oil.” In other words, prudent people’s wealth, in terms of dollars, is worth less relative to the things we want to buy with dollars.

Added to this, the rate cut caused long term and fixed mortgage rates up. Once again, this benefits the imprudent who gambled on floating rate loans and punishes the prudent who may be seeking fixed rate loans at what are now higher rates.

Those investors who stayed away from toxic waste and invested prudently are also being punished because the Fed’s bailout is helping toxic waste investors to the relative detriment of those who avoided subprime mortgage risks of all sorts (whether bonds, CDO’s, stocks, swaps, etc.).

Finally, the prudent get to bail out the imprudent in that our tax dollars will be used to bail out subprime borrowers, subprime lenders (like Countrywide), subprime investors, and the investment banks and rating agencies who should have known that subprime investments were junk.

As Sloan puts it, the Fed’s bailout allows the imprudent to play “heads I win, tails I get bailed out” whereas prudent investors get stuck with depreciated wealth, higher fixed rate loans, worse relative investment performance, and a higher tax burden.

If you’ve been imprudent over the last several years, you probably think the Fed’s rate cut is wonderful. But, for those of us who were prudent enough to avoid bad risks, the Fed’s rate cut is bad news.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The Fed to the rescue?

The Fed, also known as the Federal Reserve, had to ride to the rescue of financial markets today and yesterday.

The market suffered from a liquidity crunch this week, which means that many investors were unwilling to put their money into markets. This causes a dry up of so-called liquidity, or ready money.

You see, most financial institutions operate on a lot of borrowed money. When they can’t borrow money, their operations seize up for a lack of a better term.

The Fed came to the rescue by pumping $24 billion into the market in two transactions yesterday and $38 billion into the market in three transactions today, more than the $50 billion pumped into markets after 9/11. (As an aside, the European Central Bank pumped almost $200 billion into their markets to keep things going)

How does the Fed do this? They lend money to banks at low rates. Not surprisingly, the Fed does not create value from thin air, they must do something for this so-called liquidity to appear.

The long and short is that they “printed” money out of thin air for the banks to borrow. I put printed in quotes because it’s almost all done electronically now, so the printing is purely in computer bits.

Does such market aid come at a cost? You betcha! Printing money faster than economic growth causes inflation. As Milton Friedman said, inflation is everywhere and always a monetary phenomenon.

Perhaps that is why the price of gold decoupled from the stock market today. You see, the gold market has been moving in conjunction with the stock market lately, which is very unusual. Today it stopped moving in conjunction with the stock market, though, perhaps indicating that buyers and sellers of gold recognized that the Fed printing money to rescue the financial system is just another way of saying, “Here comes some inflation for ya!”

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.