Fed Chicken and Egg Conundrum. Dimon Proves Will Rogers Right. Banks Broke

 This article was first published by me on Talkmarkets: www.talkmarkets.com/content/us-markets/fed-chicken-and-egg-conundrum-dimon-proves-will-rogers-right-banks-broke?post=72815&uid=4798

The chicken and egg debate regarding the Fed-in-a-box theory contemplates which comes first, rising interest rates or selling bonds back into the economy and to banks.

I have discussed that there are too few bonds in the system to act as collateral for deals and derivatives. But it is proving very difficult to sell bonds to the big banks or to "other financial institutions", as the big banks have a really good deal, interest on money in the excess reserves they possess. They get less interest on bonds if they purchase them. The "other financial institutions" may be holding out for a better deal on bonds. They could even be colluding to boycott bonds.

So, the issue of trying to raise interest rates when there is the risk of deflation is a real risk. And deflation is threatening us, as many others have pointed out, from all sides, financially, globally, and technologically. Yet the other financial institutions want to buy bonds more cheaply.

The Fed is fooling itself if it thinks there is not a deflationary pressure on main street. There is. When you consider student loans, payday loans, easy money car loans and new easy mortgages, there is a definite pressure towards deflation. Main street is only deleveraging by walking away from loans and not by paying down many loans.

Main street pays on interest and doesn't spend on the economy, which needs to grow. It is growing a little, but not because of any big wealth effect, only by the borrowing and debt effect.

Raising interest rates in this environment is pretty hard to do. The Fed can bypass the big banks by selling bonds in the repo market to other institutions like hedge funds, but it has to raise rates and lower the price of the bonds in order to promise the hedge funds and small banks that it will buy the bonds back at a higher price.

So, the repo market could freeze up one day, aggravating the cold shoulder the "other institutions" are giving bond buying.

So, in a deflationary situation the Fed seeks to raise rates and lower the value of the bonds in order to get out of the debt trap. Raising rates is supposed to increase inflation and lessen the burdens of government debt and private debt. But the attempt to raise rates is being met with stiff resistance.

The Fed knows it cannot let the economy overheat. It has new tools to fight inflationary pressures, but the old tool of swift interest rate raising is gone as a tool. Too many derivatives depend on the value of the bonds being where they are. Derivatives are a real problem when it comes to the real economy.

The Fed cannot ever let wages rise significantly, and that is exactly what is needed to combat deflationary trends on main street. Demand is low for goods and services. The Fed can't let wages rise, yet cannot afford not to let wages rise.


So, here are some boxes and nonsensical conundrums the Fed is in:

1. The Fed cannot sell badly needed bonds without raising interest rates. It cannot raise interest rates without more demand for the bonds. Yet there is a massive need for bonds as collateral.

2. The Fed needs to expand the money supply to promote growth, but it needs to contract it to help banks profit.

3. Wages need to rise but the Fed no longer has tools to stop the overheating that could result.Wages need to rise but the Fed cannot let wages rise.

4. Raising rates should result in higher long rates, but in reality it doesn't. That is, of course, the Great Conundrum.

5. As Zero Hedge pointed out, the Fed is the market so how can it stop being the market?

6. Big banks profit from higher interest rates, yet Paul Craig Roberts says that low interest rates are needed to keep banks afloat. Will Rogers said that fear to raise rates shows that banks are skating on thin ice!


As an anecdotal story regarding the problem facing the Fed is the story of a relative of mine who has purchased a house slated for tear down in a bubble area. The renter of the house was the real estate agent. She was so tied up in payday loans that she had no liquidity. She has to stay in the house for months, and just pay rent. The commission will help, but it isn't cheap to move in Los
Angeles. Liquidity on mainstreet is already a problem. Can you imagine if rates are raised? The cost of borrowing payday loans would have to go up and the realtor would clearly have to default unless she sells a lot more houses.

A few years back student loan interest rates went through the roof. This is proving to be another massive drag on consumers.

Americans can't buy goods and services if they are servicing crushing debt.

Americans on the main street level need to have more real wealth and not just temporary liquidity. Banks are not much better off if they must be kept alive by low interest rates. I mentioned that fact here.


So, what is going on? I believe that derivatives are at the heart of this problem. They have bonds acting unlike they should act. They have banks acting unlike they should act. They have the Fed acting totally unlike it should act.

And now the ECB does not have enough bonds to buy.  

That leads to the third to last conundrum:

7.  No one wants to give up their bonds, (in the Eurozone), but no one wants to buy them from the Fed (in the US). Something is being rigged here. Something is not right. Banks and "other financial institutions" are forcing the Fed to raise rates even though it may not benefit the banks with a lot of deposits.

Yet Jamie Dimon has said that those pesky depositors will have to be paid more interest, and so banks won't do as well with higher rates as many people think. While the financial system is pretty well divorced from the real economy, it still takes in money from depositors and they are liabilities to the banks. Pesky depositors will want a better return and can move funds with the internet as a help.  

Jamie Dimon just admitted what Will Rogers knew to be true, that banks are weak and broke and can't afford to pay depositors a decent rate in a deflationary atmosphere.

Anyway, getting back to the original premise of the article, the chicken and egg effect, the Fed used to just sell bonds and short term rates went up. But the Fed now has to massively sell the securities in large quantities order to effect interest rates.

That could result in the "other financial institutions" like hedge funds flocking to the bonds and away from stocks, as the article link above reveals. There is a limit on reverse repos as the Fed fears this may happen. 

That leads us to the next to last conundrum:

8. The Fed must abandon the limit on reverse repos, yet it really cannot do so. The method is a new one. Some think it won't work, others think it will, but it still is taking place in a world that is distressed. If mom and pop get into the bond buying act, as I have said before, they will interfere with the financial system's need for treasuries as collateral.

So, this leads us to the final conundrum:

9. The Fed must make bonds ugly to the man on the street while making them pretty to "other institutions". That will require a slight of hand, never seen before in the annals of central banking. If many investors are willing to buy bonds with negative rates, (hoping the rates would become even more negative over time), think what massive unwanted main street demand for treasuries could occur, crowding out the derivatives crowd, if main street can get real interest from their bond investments.

That just seems too good to be true in this deflationary environment. Banks skate on thin Ice and Jamie Dimon revealed it, and that makes the Fed's conundrum a really difficult one.  


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