Thoughts on the FED and DEFLATION

• Fed sets the discount rate i.e. the near term lending rate to banks
• This is an inter bank lending rate
• The Fed follow the 3 month T Bill rate so the market effectively sets the rate
• Regardless of fed funds rate – banks set their own lending rates to customers so even if the fed funds rate is close to 0%, bank lending rates can vary from low to high depending on how they view the economy and the credit risk of the borrower
• During bad times bank may not even lend even if the fed funds rare were at 0%
• They will raise their loan rates to make up for the risk of loss – this is what is happening in the market right now
• In UK – base rate is close to 0% but banks are lending for homes, cars, education and credit card at much higher rates
• The common man cant access the 0% short term rate – may be some home owners who have their mortgage linked to short term variable rate may enjoy very low monthly installments but this cant go on forever
• Banks can cease new commercial and consumer lending if they think the economy is set to get worse
• Fed cant force the banks to lend and neither it can force the common man to borrow
• This is what has been happening in Japan for over a decade where rates are close to 0% but the volume of credit is still contracting
• People think that the Fed can just print money and solve the crisis – this is just impossible
• Fed is a bank – why would they want to go broke by buying worthless portfolios of loans so they wont take on bad debt on their books from other banks
• Even in 1933 – Fed offered cash to banks in exchange for only the very best loans in the banks portfolios and it did almost the same in 2008
• They can’t print money because that would signal the bond holders that their purchasing power is being debased. Even before that is done they can dump the bonds causing rates to rise and cause market havoc. This would be deflationary.
• We may see deflation first and then there may be a chance for a hyper inflationary outcome. But it can happen in the next Kondratieff cycle and not now.
• Fed also pays 6% guaranteed dividends – do you think their stake holders would want to Fed to be destroyed either by taking worthless bad loans on its books or by hyper inflating the currency to cause a market collapse
• Finally the main responsibility of the Fed is to provide backing for the nations currency so it does not care in the end if some banks survive or crash