The Fed deals with Trump spending mania on the right (Trumponomics), and will do so if necessary, with Modern Monetary Theory (MMT) wanting to spend to oblivion on the far left. Trump wants to bust the new normal of slow growth and low long bond rates. MMT wants to bust the new normal of slow growth as well.

In one very real sense, you cannot blame those who feel the current economic system is denying opportunity to too many people. Yet their far right and far left solutions are potentially worse than the disease.

But the Fed has hinted that it is not interested in inflation, or big growth or massive increases in the money supply. It is interested in increasing the money supply, but by a measured increase. Now the Fed has paused, saying there is a slowdown in the world economy. It will buy some treasury bonds when selling mortgage bonds. That is not yet QE, but it is a way to increase the money supply at a measured rate within the framework of the new normal.

What the Fed Is About

Chairman Jerome Powell said Trump can't fire him. The Fed is a powerful institution. We all should read Fed watcher Jeffrey P. Snider. It isn't necessary to agree with everything, and I show an area of minor disagreement below. But his research is brilliant, invaluable, and enjoyable.

Here is the newest astonishing hint about what the Fed is, well, about. It was found in an article on Talkmarkets by Jeffrey P. Snider. It is interesting that we are already talking about the Fed being unable to distance itself from the Zero Lower Bound as it has paused raising rates due to the weak economic reality:

In addition to assessing the efficacy of these existing tools, we will consider additional tools to ease policy when the ELB is binding. For example, as is presently Bank of Japan policy, the FOMC could, when the ELB is binding, establish a temporary ceiling for Treasury yields at longer maturities by standing ready to purchase them at a preannounced floor price. [Emphasis mine]

Say what? What? A temporary ceiling is needed for treasury yields? Effective Lower Bound (ELB) is nominal interest rates at zero. The Fed fears people won't buy as many bonds as yields settle at zero, and therefore yields will rise. But, the Fed will protect the bonds so yields don't rise at ELB.

This pretty much proves that the Fed believes in the price of bonds, 1. as collateral, and 2. as attractive investment for sovereign purchasers, and 3. as providing liquidity to domestic mortgages and auto lending, is more important than an explosion of long bond (10 year) high yields, say much above 3 percent. I have been saying this for a while. Most don't understand but it is how the Fed thinks.

There is often no need to create a ceiling for yields as long as there is some positive yield, because demand is usually always there. It is just when the zero lower bound is reached that a cap is considered to make sure that even if demand slumps, the price will be preserved at that time.

The Fed will choose to save the banks and the collateral and throw the real economy a helpful bone as the 10 year determines mortgage rates. Yes, the Fed does not want a deep recession and fears deflation, but obviously is comfortable with the new normal. The old idea that when there is a boom in stocks (not necessarily the real economy), that people will stop buying bonds is likely no longer true due to the added usefulness of bonds as collateral. 

US bonds are favorable to most in the world for stability and for price. Collateral is usually scarce, still is in the EU and elsewhere. We already know that Liberty Street believes long treasuries have a demand of their own. Apparently, the Fed as a whole has embraced the Liberty Street concept.

Misplaced Fed Analysis

So, bottom line to all this is there is a massive amount of analysis of the Fed that totally misses the boat about long bond yields. Those yields are determined by massive demand for collateral and by the Fed bond purchases when necessary. Even the Fed may say, well inflation is on the way. Jeffrey P. Snider points out the Fed says inflation is on the way and we know they wanted normalization of bond yields. That is a pre-planned rope-a-dope in my opinion. They know historical normalization is not possible.

I realize that Jeffrey P. Snider has said previously that inflation is a safer policy to endure than is deflation. I am not saying that is not true historically. But in the new normal, when the Fed has to choose between slow growth and the threat of deflation, or on the other hand, inflation, it will always, yes always, choose slow growth with a risk of recession over inflation.

However, Snider says something about the conundrum of low rates that I don't fully agree with:

You can already see the conundrum for what it really was. If inflation or whatever other monetary characteristic was not well-behaved, where would the Fed even begin? That has been the history of the last ten years in particular, where once things started to go wrong none of the central banks had a real idea what it was that was wrong, let alone any further idea what to do about it.

I believe that the Central Bankers appear to not know what they are doing. But they do know what they are doing in the setting of the new normal. They are for it. They are convinced of its value. They do not want to change it. Snider is absolutely correct that the economy is not and likely will not boom like the glass half full economists say. But he says it is Fed incompetence. I say it is deliberate Fed behavior based on the need for long bond low yields.

The financial system then, is not geared in any way to breaking the new normal. Failure of the new normal would likely hurt the output of goods in the USA and the world, making us all poorer. This is my opinion, and no one really knows what the end game would look like. But there is not much more that is as risky to contemplate.

POTUS may want to fire Powell, or stack the Fed with his cronies like Stephen Moore, or stop the Fed from stopping him. But, for good or bad, it isn't going to happen. Trump cannot break the new normal, ruin the collateral, and expand the money supply massively. 

The Fed Problems

The Fed has some big problems and here are a few. Their clever plan is functioning. But there is risk for it too.

A. One such problem is the yield curve. Jeffrey P. Snider weighs in:

For the past few months, then, central bankers have backed off not just in the US but all over the world. Mario Draghi in Europe was going to raise rates this summer, instead, the ECB will be offering a third T-LTRO. Haruhiko Kuroda should’ve ended QQE but that will probably get supplemented. The PBOC is doing a bunch of things and no matter why this will be called “stimulus.”
If “hawkish” monetary policies cumulative broke the markets, then shifting this way should undo some if not all of the damage. That’s the thought, anyway.
Yeah, no.

He goes onto say that the yield curve is flattening, and the Eurodollar curve is flattening, and the R*, the natural rate of interest, could be dropping. All this slowing could be recessionary. But remember, in my opinion, the Fed will risk a mild recession, as long at it does not allow inflation.

However, before investors get too smug, Scott Sumner has said that the USA is a clumsy nation, less capable of soft landings than other, smaller nations. 

B. Stagflation, as mentioned by  Talkmarkets founding contributor, Vivian Lewis, would be an interesting scenario and a problem for the Fed. I can't see the Fed allowing it because it would let inflation out of the bag, and result in a definite and decisive inversion of the yield curve. Remember, long yields cannot go much higher than 3 percent.

C. The central bank has the problem, according to Snider, of the Eurodollar banks and system. As Fed rates go up on the short end, those Eurodollars become more expensive to obtain.

The Eurozone is really slowing, and it is in large part because China is slowing. For Jeffrey, the problem with the Fed is that the money supply is simply not increasing fast enough. But that is exactly what the Fed wants. The problem is, of course, that if money supply growth is too slow, it could ruin Main Street, especially in the Eurozone, and other nations, especially in continued downturns.

The Fed must shudder at the thought of bailing out insolvent European banks again like in the Great Recession. So, it will likely increase the money supply some, but could be late to the expansion game.

D. While US banks did pay back TARP, they got sweet interest rate deals under the program, and then jacked up rates for the regular folk. Borrow at almost zero and raise rates on credit cards to 16 percent and higher for people with good credit.

People like Mnuchin and others foreclosing ruthlessly. Now he is in government. Tim Geithner being rewarded with Treasury Secretary after presiding over a nasty housing bubble and crash as New York Fred president, while forgetting to file his taxes.

The Fed has a PR problem of immense magnitude. How that will play out in the next downturn is hard to know. Does the Fed, by its policies, want to keep breeding generations of young Americans who feel abused by the financial system?

Crush inflation, just don't crush Main Street. Only helicopter money, a one time measured gift, can prevent both in a big downturn. It would increase the money supply, but not in an out-of-control way advocated by MMT and Trumponomics. There may be no other way out unless unstable folks want potentially very dangerous wars.