Saturday, January 03, 2009

How Low Can the Fed Go? All the Way to NIRP

Fed leaders are signalling their willingness to further shred the value of the U.S. dollar and investors' money market accounts through more quantitative easing:

A grim economic outlook highlights the need for the Federal Reserve to step up quantitative measures to boost growth, with official interest rates already effectively at zero, Charles Evans, president of the Chicago Fed, said on Saturday.

Evans said that based on the outlook for rising unemployment, falling industrial production and a wider output gap, economic models suggest rates should be below zero.

However, there is some dissension in the Fed's ranks. Another Fedster thinks it wise to hedge bets and prepare to address the inflationary future that the Fed's policies have made very likely:
Setting an explicit inflation target would help the U.S. Federal Reserve keep deflation at bay now that interest rates have been cut to almost zero, a top central banker said on Saturday.

"Now would be a particularly good time to do that because you have this possibility of expectations drifting off to deflation or a lot of inflation," James Bullard, president of the St Louis Federal Reserve Bank, told a panel discussion during the annual meeting of the American Economics Association.
Nowhere in the article does Mr. Bullard say the Fed should actually curtail its quant easing. He seems to say the Fed should take stronger steps to "signal" its concern about inflation, as if somehow the economy's deflationary output decline can do the Fed's inflation-fighting work all by itself. The risk in whistling past the graveyard like this is that one may not know where the graveyard ends. Combining quant easing with declining goods availability actually widens the graveyard, so the Fed's governors will need all the lungpower they can muster.
I'm not the only independent observer who thinks the Fed has risked the health of both its balance sheet and the U.S. dollar on a wild macroeconomic experiment:
The Federal Reserve has embarked on a campaign of unsupervised industrial policy to end the country's financial crisis, a move that could undermine its independence, a former top U.S. official said on Saturday.

John Taylor, who was under secretary of treasury for international affairs from 2001 to 2005, said the explosive growth of the Fed's balance sheet since September was "unbelievable."
Unfortunately, Helicopter Ben is flying at full speed and has no time to read those kinds of warnings. Now that the U.S. has won the central bankers' race to ZIRP, the next race will be about NIRP: Negative Interest Rate Policy.

It's no longer a question of whether the Fed will pursue negative real rates. That die is cast. The bond bubble thus has further to run, at least a quarter or two. After that, serious inflation will be baked in to the U.S. economy and gold will be a very attractive alternative to the dollar.

Full disclosure: I'm long IAU and GDX but not GLD. I'm seriously considering buying more of IAU and GDX, or even selling puts against GLD (which now has a much deeper option chain than IAU).