The Fed's Problem

Not sure anyone has analyzed the technical problem that the Fed faces here more than John Hussman. Dr J has examined the historical relationship between T-bill rates and monetary base per nominal dollar of GDP (a.k.a. 'liquidity preference').

The results show an asymptotic relationship. When rates are high, people have less desire to carry money around because of opportunity cost. When rates approach zero, however, people are increasingly prone to hold cash because there are few competing uses for it.

I like to think about this in terms of cash that I am holding in investment accounts. I would like to put this cash to work in short term vehicles, but alternatives such as 3 month T-bills or 3 month CDs are yielding next to nothing. Thus, I'm comfortable just staying in cash because at least I am in a flexible position to deploy it should opportunities arise. To me, that is worth more than the pathetic yields I would be getting by tying up cash in short term fixed income vehicles. Just as John's analysis shows, ultra low interest rates have me holding more cash than I otherwise would.

The problem for the Fed is that in order to press interest rates closer and closer to zero, the amount of base money that the Fed has to pump into the system via its asset purchase programs such as QE2 must grow exponentially. Any exogenous forces putting upward pressure on rates (e.g., perceptions about inflation, slow down in offshore Treasury buying) must be met with ever more money printing by the Fed, otherwise all of this money that has been created would quickly seek other uses, and prices of many things would explode higher.

Since the Fed is approaching the zero bound for interest rates, it stands to reason that at some point, perhaps soon, the Fed will be physically unable to suppress rates further in an environment where exogenous forces are pressuring people to reduce their liquidity preference.

Should we reach this point, the Fed faces one of two alternatives: a) it could sit back and watch prices rip higher as people swap out of cash perceived as a rapidly depreciating asset, or b) it could rapidly withdraw the funny money that it has been pumping into the system.

Remember the nonlinear relationship between money printing and interest rates, however. The Fed would have to remove a disproportionate chunk of stimulus in an attempt to normalize rates just a fraction higher than where they currently stand. Dr J estimates that, in order to normalize short rates at 0.25 - 0.50%, the Fed would have to reverse its entire $600 billion QE2 program.

The point is that, if the Fed tries to tame inflation at this point, it will have to suck gigantic amounts of liquidity from the system. If the Fed decides not to do this, then prices of most things are certainly headed much higher.

This is the box that the Fed is in.

This situation also goes a long way toward explaining the action in precious metals. Investors have sniffed the Fed's bind out, and are bidding gold and silver up on a bet that the Fed will choose option a) above.

Before us is a game of chicken of historical proportion.

position in gold, silver