Fed’s Backdoor to Negative Interest Rates

Published by clickbroker.blogspot.com

By now, every living cable viewing being has seen the P90X infomercial touting the fitness benefits of “muscle confusion.” Their theory is that bulk building plateaus when your muscles get used to the same movements. The secret goes, mix up your routine and you’ll get extraordinary results. Faster results than you ever dreamed possible.

From the YouTube videos of the P90X cult followers, we get the real life before and after pictures by week for the first 90 days. You may want to hide your eyes. While the laptop cam reality players haven’t lost their enthusiasm, they admitted they are having trouble keeping up with the program. And confused or not the reality players don’t match the muscle tone or bulk of the infomercial actors.

The confusion that Federal Reserve Chairman Ben Bernanke has created over the last two years has not done anything to improve the nation’s brain tissue bulk or toning either. Even a man of substantial physical and mental bulk, former Federal Reserve Chairman Paul Volcker has verbally challenged Bernanke’s 2% inflation target. If Volcker doesn’t get it, than there is little hope for the rest of us.

That is until The New York Times’ “It May Be Time for the Fed to Go Negative” explains Bernanke’s logic. The Fed has already lowered short-term interests to zero, and the numerous other credit creation programs are doing little to motivate consumers to actually spend. Increasing the supply of credit is like leading the horse to water, but as the say goes, getting the horse to drink is another matter.

Asking consumers to accept the bank charging them for their savings account or CD is as fortuitous as borrowing $100 from the bank and only having to pay back $97. Bank of America (BAC) CEO Ken Lewis said in the Q1 conference call that deposit interest rates needed to attract savers have reached their cycle low, so the NYT example of a negative 3% interest rate will never happen. Savers would keep their money in a safe deposit box and lenders just wouldn’t lend. Just like the behavior of gold.

Helicopter Ben is not one to be stopped by the constraints of mere mortal behavior. The Fed has historically lowered interest rates below inflation to motivate spending. And we have had negative real interest in many periods of our financial history. What is different this time is that nominal short-term interest rates are already at zero, so even Bernanke has to admit that they cannot be lowered any more.

So if Bernanke cannot lower nominal interest rates, but still wants to cut real interest rates further what does he do? The NYT hit the jackpot; create the belief of sustained inflation for the foreseeable future. Higher perceived future inflation implies greater negative real interest rates and greater enticement for businesses and consumers to spend now. So you see my dear Watson, interest rates really can go below zero.

In order for Bernanke to motivate spending, the inflation fear has to be large enough and sustained enough to overcome the hoarding instinct in times of economic fear. Sorting through the confusion of Bernanke’s mixed messages cannot be any clearer. Sustained and increasingly negative real interest rates for the next decade is the message to the finically astute. And excess liquidity will be removed before inflation starts is the message for the politicians and the general public. Trouble is Volcker caught Bernanke and his cohorts with their shoes untied.

Bernanke’s P90X program is perfectly clear: The Fed is bulking up on inflation, whether its muscles are confused or not.

Disclosure: Author is long BAC.

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