Fed Hit By Subpoena & Money For Uncle Sam

By Axel Merk

Merk Hard Currency Fund

June 11, 2009

Fed Hit By Subpoena - Fasten You Seatbelt

The Federal Reserve was served a subpoena from a Congressional committee Tuesday, as lawmakers demanded documents related to Bank of America’s acquisition of Merrill Lynch. In our view, this is a precursor of more trouble to come for the Fed.

We have argued for some time that Fed Chairman Bernanke completely underestimates the political dimensions of the policies he pursues. The various "credit easing" programs have little to do with monetary policy, the domain of the Fed. Monetary policy ought to be concerned with money supply or the level of interest rates, thereby allowing the markets to decide where the money flows.

Instead, the Fed has been targeting specific sectors of the economy, such as helping the housing market or enabling car loans. The motivation is understandable, as the Fed is well aware that it may not be powerful enough to support the housing market otherwise, and sees it as crucial in its plan to prop up the economy.

However, allocating money to specific sectors of the economy is fiscal policy and, as such, should be authorized and supervised by Congress. This facet is perilous for the Fed to ignore, as it invites political backlash. Last week, Bernanke was grilled by the House Budget Committee, giving him a taste of more to come; the subpoena is a further step.

The ‘unconventional’ policies jeopardize the credibility and independence of the Fed. This takes its toll on the effectiveness of monetary policy, making any policy more expensive. Remember: the cheapest monetary policy is one where a Fed official simply utters a few words and the market reacts. Ever since the fall of 2007, monetary policy has become increasingly more expensive as the Fed’s effectiveness has been eroding. When Fed talk was no longer sufficient, the Fed had to enact an emergency rate cut in early 2008; since then, the Fed had to escalate its policies further, printing trillions of dollars.

Unfortunately, this trend may accelerate rather than reverse. Fasten your seatbelts.

Money For Uncle Sam

In our estimate, the U.S. Treasury will have to raise over $2 trillion dollars this year to finance new obligations. In addition, over $2 trillion in government debt held by the public is coming due and has to be re-financed this year.

My pocket calculator tells me that this requires over $15 billion of government debt to be issued every business day. Note that summer months tend to be bad months to issue debt, as many buyers, including foreign buyers, tend to take vacation. Conversely, it looks like vacation has been cancelled for the U.S. Treasury’s debt issuance department.

On Wednesday, the Treasury issued $19 billion in 10 year notes; on Thursday, another $11 billion in 30 year bonds will be sold. Those happen to average $15 billion a day, but these are the highlights of the week and the government will need to ramp up future issuances substantially to meet its funding needs.

However, the government is not the only party issuing debt. A lot of corporate debt needs to be rolled; and a lot of foreign governments and corporations need to raise unprecedented amounts of debt. So far, there seems to be appetite for Uncle Sam’s debt, but the cost is rising; at the auction today, creditors demanded a yield of 3.99%, up from 3.6% only a week earlier.

In our view, the cost of borrowing may rise dramatically this year; a big unknown is whether the Federal Reserve will allow this to happen, as a spike in borrowing costs could put any nascent recovery into a tailspin. The Fed may step in and finance the deficit - to an extent, this is happening already, as the Fed has been buying government bonds, but the activity would need to be ramped up dramatically to keep borrowing costs low. At this stage, the Fed denies it will print money to finance deficit spending, although this may be more about semantics than substance.

If creditors are not properly compensated for the risk they take (which is the case when the Fed artificially keeps long-term borrowing costs low), the U.S. dollar may fall sharply. It is also possible that the Fed will be overwhelmed by market forces: the Fed may be able to print money, but it is not almighty; we may end up with a weaker dollar and higher borrowing costs.

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