And so tightening begins?

February 19, 2010

No, not really.

Raising the discount rate a quarter point is a start, but as the Fed went to pains to explain, it doesn’t indicate broader tightening of credit. For that we have to wait for some combination of the Fed shrinking its balance sheet along with a hike in the Fed funds rate and, perhaps more importantly, a hike in the rate paid on banks’ excess reserves.

But meaningful tightening may never happen. Unless we get a dollar crisis — a possibility if the printing press runs on high too long — the Fed won’t be able to raise rates for the simple reason that it is trapped.

Why? Two reasons jump to mind:

1. Banks are still carrying trillions of dollars of loans collateralized by real estate, loans that will lose significant value and wipe out still-thin capital cushions if interest rates move up in any substantial fashion.

Remember that real estate prices move in the opposite direction of interest rates. Incomes can support a certain monthly payment for a mortgage. Higher rates mean a larger component of that monthly payment has to go towards interest. The price has to correct accordingly.

2. America is still deep in debt. Federal, state and municipal governments, private pension plans, households, in the aggregate we still owe lots of money. And that debt is constantly being rolled over. Raising rates would make rolling the debt much more difficult, stopping the “recovery” in its tracks and leading to massive deflation.

The Fed would only risk that if it were faced with a dollar crisis. It would be wrong to expect such a crisis any time soon. But after multiple cycles of quantitative easing — the first round may be winding down, but expect it to come back in the future — a dollar crisis may not seem so far-fetched.

In the meantime, don’t be fooled. Bernanke has shown no sign that he’s willing to put up with the kind of recession that is needed for the economy to de-lever. Meanwhile the federal government will keep borrowing to make sure that we don’t.


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I am somewhat of an amateur at this. What kind of recession would be necessary in order to de-lever?

Also, regarding the federal government and the rolling over of debt, once the dollar crisis hits I imagine that treasury rates will have to increase substantially in order to retain demand for our debt. How can the US government continue to make interest payments on treasury bills once our yield rates rise to say 10-15%? Those kind of interest payments on trillions of dollars of debt would make up a huge chuck of the fiscal budget.

I also imagine the high yield rates on treasuries will be mirrored at the discount window, making it even harder for businesses (our economy) to finance growth.


Posted by Matt-Chicago | Report as abusive

Hi Rolfe
Are you concerned with the $640 Trillion dollar derivates market?
I just don’t see how the American Economy will escape that 600 LB gorilla.
It’s like everyone thinks it’s not there or they pretend it’s not.

Posted by BrianOmdahl | Report as abusive

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