A Conflict that Bodes Ill for the Dollar

By Michael Pento | June 11, 2008 | 10:45 AM | 4 CommentsTweet This

Lately, there has been much talk coming from the Fed chairman intimating that he is poised to raise interest rates significantly to squelch the rising tide of inflation. I'm encouraged that he has now acknowledged that inflation is pushing consumer's balance sheets over the edge.  I would welcome a Fed that takes a lesson from Jean-Claude Trichet and the ECB, focusing on fighting inflation rather than attempting to stimulate growth. However, I will have to curtail my enthusiasm and caution investors to position their portfolios for an economy that may instead continue to be hampered by inflation.

I've written recently as to why I feel investors should not take seriously Bernanke's rhetoric about fighting inflation and protecting the dollar. I've also touched on how the consumer's debt ratio is at its highest level in history while economic growth is negligible and job creation is absent. That is not an environment where one would normally expect Federal Reserve interest rate hikes, even though we concurrently have inflation rates at a multi-decade high. But there is an important new reason why the Fed's hands may be tied for quite some time.

We can all agree that the progenitor of all the economic distress was the bursting of the housing bubble. One of the Fed's main tools to rescue the banking system is the Term Securities Lending Facility (TSLF). Basically, this off balance sheet asset swap involves the Fed exchanging Treasury securities for mortgage backed bonds held by banks. Unbelievably, we have allowed our money and currency to be put at risk by an institution that is unaccountable to the taxpayer. Indeed, the Fed conducts its operations in such secrecy that we don't even know the degree of the haircut being taken on these securities. And since it is an off balance sheet transaction, we do not even know the true rate at which the monetary base is truly growing. What we do know is that the Fed has exchanged about half of its $800 billion dollar sources side balance sheet for these risky, priced-to-model CDO securities.

The point is obvious: the Fed now has a conflict of interest it has never had before.

Normally the Fed is concerned with balancing growth with inflation. But now it has some significant skin in the game. The rate of inflation is currently above Gentle Ben's comfort zone, so under normal circumstances we might expect substantial interest rate hikes to protect the falling dollar and bring costs under control. However, will the Fed really do something which would so adversely affect its own holdings? By taking assets onto its balance sheet that will decline when home prices fall, the Fed may very well be inclined-even forced-to  act in its own self interest and not in the interest of sparing consumers from rampant inflation.

The Federal Reserve may now have a new mandate: to protect the mortgage backed bonds it holds.

By raising rates now the Fed would slow the economy further while increasing the costs associated with owning a home. The real estate market is showing few signs of recovery and the supply of homes on the market is still at a record 11.2 months inventory. Investors must keep in mind that Ben Bernanke is no longer an objective third party trying to steer the economy; instead, he must now consider the assets in his own portfolio.

His new position as a portfolio manager could well prevent him from delivering increasingly-expected rate hikes. The more you know about the Fed and its chairman, the less you should be able to believe in a dollar bull market and the more you should fear a protracted bear market has only just begun.

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Jawboning Is All Bernanke Can Do If Bernanke lowers rates, then he is percieved as igniting inflation to an even greater extent than he and his Fed alreday have; if he raises rates, the Fed is seen as slowing economic growth at a time when the economy is sputtering. Option #1 (lowering rates is unlikely) and option #2 (raising rates) is unlikely for following reasons: 1) election year politics; 2) Fed policy would be seen as too reactive and scatter brain. So what else can Bernanke do? The only thing left is to jawbone the markets and it this does not appear to effective until the Fed is willing to "walk the walk" and follow through on their words. Dollar technicals: a monthly close over $73.11 would be constructive if not bullish Submitted by Guy Lerner on Wed, 2008/06/11 - 11:03am » reply |

I agree that this creates a I agree that this creates a conflict of interests. From a little research on TSLF, I see that under this program the Fed can lend a maximum of $200 billion. http://www.federalreserve.gov/newsevents/press/monetary/20080311a.htm Could you explain what you mean above: "What we do know is that the Fed has exchanged about half of its $800 billion dollar sources side balance sheet for these risky, priced-to-model CDO securities." ? How is this possible? Submitted by Dracop on Wed, 2008/06/11 - 11:20am » reply |

You must add the Term You must add the Term Auction Facility (TAF) and the extension of the discount window to investment banks to the TSLF to get the total of $400 billion. I should have made it clear. Thanks Submitted by Michael Pento on Wed, 2008/06/11 - 1:26pm » reply |

Surprise to me! Fed Conflict of Interest! http://globalcapital.blogspot.com Good article. I had begun to wonder why the Fed had reversed itself and suddenly started to talk UP the Dollar after refusing to discuss the Dollar at all in the past. Obviously, something has changed. Inflation is becoming unhinged (probably already has). But inflation concern it likely to remain JUST TALK. This helps to explain why there is so much TALK about the dollar, but no action to defend it. With all the damage the Fed has done to itself and the loss of credibility it has suffered, this latest jaw-boning will eventually be perceived as just talk. Then, the Fed's cred will be damaged even more. Thanks to your article, you have raised my awareness to a new frightening variable that could have some disastrous consequences down the road. I shudder to think what the Fed is doing to this nation. Submitted by sbenard on Thu, 2008/06/12 - 7:42pm » reply |

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