Primer for Mr. Kohn: Bond Prices and Interest Rates Move Inversely

Do you know what? Some days we’re not sure whether to laugh or really laugh.

Yesterday, as we took a break from cobbling together the March issue of Australian Small-Cap Investigator, we glanced over a speech given by Donald Kohn, vice chairman of the US Federal Reserve.

Look, read the whole thing for youself by clicking here. To be honest, it’s a joke from start to finish, but it’s worth reading so you’ve got some idea about the brain power of the clowns running the show.

Take this as an example:

“We are also uncertain about how, exactly, the purchases put downward pressure on interest rates. My presumption has been that the effect comes mainly from the total amount we purchase relative to the total stock of debt outstanding. However, others have argued that the market effect derives importantly from the flow of our purchases relative to the amount of new issuance in the market.”

Oh Lordy!

Well, here’s a primer for Mr. Kohn. Bond prices and interest rates move inversely. A rise in the bond price means a decrease in the interest rate. A fall in the bond price means an increase in the interest rate.

It’s not hard. In fact we’ll guess it’s probably on the syllabus of any high school economics class.

So here’s the revelation for Mr. Kohn, when the Federal Reserve announces it’s going to buy securities, market participants know that the banker to the government has unlimited funds and will therefore pay top dollar.

Therefore sellers are encouraged to demand a much higher price than they normally would – remember, a higher bond price equals a lower interest rate.

That the vice chairman of the Federal Reserve is perplexed about this is astounding. In fact it’s comical.

But if you think that’s worrying, just wait until you read what else he had to say about interest rates at the Cornelson Distinguished Lecture at Davidson College, North Carolina…

“Some observers have attributed the bubbles observed in some asset prices in recent years to a decades-long downward trend in real interest rates. In this view, the decline in interest rates has caused investors to reach for yield by purchasing riskier assets with higher returns, driving the prices on riskier assets above fundamental values. Many critics of central banks ascribe the drop in real rates to monetary policy decisions that kept rates unusually low, on average over the business cycle.”

Well, we’re one of them. In our view it’s unarguable, because that’s what happened. But don’t be silly, according to Mr. Kohn, that wasn’t the problem at all:

“From my perspective, the decisions the central banks were making about their policy rates were shaped by the underlying determinants of the balance of saving and investment…”

Stop! I’ll give you some latitude with this vice chairman, but get to your point quickly…

“… The balance of saving and investment, including, in the past decade or so, the high saving propensities of the newly emerging Asian economies and the sluggish rebound in investment globally after the recession early last decade.”

That’s right, blame it on the Asian economies. So it wasn’t that Western economies spent trillions of dollars on the never-never, it was that Asian economies tucked a few yuan, ringgit and yen away for a rainy day.

And naturally enough, if you fail to acknowledge the mistakes of the past, then you’re destined to repeat the same mistakes. Which explains Mr. Kohn’s ideas for how to avoid the credit meltdown next time:

“We simply do not have good theories…”

Correct. Oh, sorry, I interrupted you. Please go on…

“We simply do not have good theories or empirical evidence to guide policymakers in using short-term interest rates to limit financial speculation. Given our current state of knowledge, my preference at this time would be to use regulation and supervision to strengthen the financial system and lean against developing problems.”

In other words, more regulations are what’s needed, not sound money policies. The idea that regulation can fix things is a joke. It’s the equivalent of someone bombing a crowded market each day and then wondering why so many people keep dying.

So as a solution they suggest giving people armoured clothing. No, that’s not the solution, stop setting off bombs, that’s the solution!

But quite frankly it’s hard to take his argument seriously when Mr. Kohn concludes with the comment:

“Central bankers, along with other policymakers, professional economists and the private sector failed to foresee or prevent a financial crisis that resulted in very serious unemployment and loss of wealth around the world. We must learn from our experience.”

So what he’s suggesting is that the people without “good theories” and what is clearly a poor “current state of knowledge”, and who “failed to foresee or prevent” the meltdown, should be given more power and responsibilities to not see the next meltdown.

But as is the done-thing with those in the mainstream, because they failed to understand that manipulating interest rates would lead to disaster they continually refuse to accept that anyone else could have spotted it.

Clearly, Mr. Kohn and his central banking cronies aren’t avid readers of The Daily Reckoning. Our sibling newsletter has been banging on about it since 1999. And they’ve obviously never heard of the likes of Peter Schiff, Congressman Ron Paul, or the Austrian School of Economics which warned of this very problem years ago.

In fact, the Austrian School rang the alarm bells before the Great Depression of the 1930s. So for Mr. Kohn to claim that “professional economists and the private sector failed to foresee” the meltdown is disingenuous to say the least.

However, it’s not just the vice chairman of the Federal Reserve who’s been thinking out loud. Fellow Fed member, Janet Yellen, President and CEO of the Federal Reserve Bank of San Francisco has done pretty much the same thing.

In this case, a presentation to the Town Hall Los Angeles. You can read the transcript here.

A couple of things amaze us with Ms. Yellen’s speech. First is the recognition that “Growth in the past decade – especially in the overheated housing market – was fueled by easy access to credit”, but then stating “And, in order to provide further stimulus, we put in place an array of unconventional programs to speed the flow of credit to households and businesses.”

It’s what we’ve stated all along, it’s just not logical to try and ‘solve’ a credit problem by encouraging the further expansion of credit. That the people at the Fed are either incapable of recognizing this, or they intentionally misinform is amazing.

But that’s not all, Ms. Yellen uses one of our favourite economic terms, the Output Gap. We’ve railed against this bit of mainstream economic nonsense before, but here’s another go, just in case you missed it…

Yellen states:

“Economists use the term ‘output gap’ to refer to an economy that is operating below its potential. We define potential as the level where GDP would be if the economy were operating at full employment, meaning the highest level of employment we could sustain without triggering a rise in inflation. Obviously, with the unemployment rate so high, we are very far from that full employment level. In fact, the output gap was around negative 6 percent in the fourth quarter of 2009…”

Got it? In a nutshell, apparently, the whole Output Gap theory claims that inflation isn’t possible while there is an Output Gap. Where the actual level of GDP is below the level of its full potential. Of course, that’s absolute nonsense.

Any person even with a pea-sized brain – such as your editor – can see that’s not true. Unfortunately it’s a theory that’s taken hold amongst mainstream economists, those in Australia included, such as Macquarie Group’s Rory Robertson.

We can see it’s not true in two ways. First, if we use the increase in the money supply as the measure of inflation then the money supply has increased enormously in the last two years, by a rate even greater than in previous years.

And secondly, even if we measure inflation as rising prices then Yellen’s own speech nullifies the reliability of the Output Gap. As she explains:

“One simple gauge of these trends [in price inflation] comes from looking at the US Commerce Department’s price index for core personal consumption expenditures, which excludes the prices of volatile food and energy products. These prices have risen a modest 1.4 percent over the past 12 months…”

So much for the idea that the Output Gap prevents inflation! But Yellen doesn’t even acknowledge the fact that even though the US is experiencing the worst depression since the 1930s, prices are still going up.

I mean, she points out that unemployment is still at 9.7%, a decrease in the workforce of around 6% in just a couple of years, yet prices have still risen. Surely that’s not the kind of thing you want to have happen when you’ve just lost your job.

Do you see how beneficial price deflation is? Prices go down to make the cost of living lower when the economy hits the skids.

But the duplicity doesn’t end there. Take this self contradiction. In one part of the speech Yellen explains:

“An independent Fed would allow interest rates to rise if needed to address inflationary pressures and resist calls to monetize the debt. By contrast, a central bank that wasn’t independent might succumb to demands to keep rates low, even if the economy were in danger of overheating.”

Just to be clear, Yellen is arguing that the US Federal Reserve is independent. Therefore an independent Fed wouldn’t monetize debt and it wouldn’t keep rates low in the face of an overheating economy.

Well, that obviously isn’t true. We’ve seen that in recent and not so recent history – including right now. But we don’t even need to rely on history to counter her claims. We can just read the speech further:

“In broad terms, the main way we expanded our balance sheet was by buying assets such as mortgage-backed securities, paying for them by crediting the sellers, and ultimately the banking system, with reserves – that is, with deposits at the Federal Reserve. Those reserves are the electronic counterpart to cash.”

In other words, the Fed ‘monetized’ the debt.

Look, the reason I’ve pointed this out is simple. Almost every day you’ll read commentary in the mainstream press that lauds central bankers as the biggest brain boxes known to mankind.

The printed and television media fawns over every word, assuming that anything said or claimed by a central banker – including Glenn Stevens – must be true. After all, they should know, right?

The fact is very different. The fact is as you can see from Kohn’s and Yellen’s speeches, these folks have less of an idea than the average man in the street. In fact, they’ve less of an idea than a below average man in the street.

That they are unable to admit or recognize the effect that manipulating interest rates has on an economy is astounding. And that they base their policies on clearly inaccurate and dangerous theories as the Output Gap is equally astounding.

As you know, I always encourage you to not take things at face value – including what we write – but instead to question everything. By now I reckon you’ve caught on to the idea, it’s just a shame the chumps in the mainstream press are yet to grasp it.

Be prepared for more information by the mainstream press as the global economy supposedly heads for recovery.

Cheers,
Kris.

Tagged as: australian small cap investigator, bond prices, Donald Kohn, interest rates, us federal reserve