Jawboning

It's about 4 months old, but I stumbled onto the November 2012 client letter put out by Sitka Pacific Capital Management. Really interesting and does the best job I have seen lately of explaining why the Fed can never let up with money printing and debt monetization – at least, not until the currency or bond markets force it to. So, any recent conversation that it might happen, based on suggestions in the Fed minutes, is just more silliness along the lines of the “fiscal cliff”.

The key points:

-As we know, interest rates are very low.  A partial implication is that the cost of debt is very cheap for Uncle Sam.  But, conversely, in such a world, if rates are allowed to rise (and you are deluding yourself if you think rates would stay where they are without the Fed supporting the market), there is a spring-loaded effect on the budget.  Each 100 bps move up equates to $160 billion more in interest expense (and that's only if you assume that debt levels stop increasing). Therefore, instead of the current $400 billion in annual interest expense, the number could easily shoot up to $1 trillion or more (representing some 40+% of collected taxes). That simply is not sustainable.

-The interest payments that the Fed receives on the debt that it buys are returned to the Treasury each year. Yet another reason that total interest expense in the federal budget is not higher. Thus, if the Fed stops buying and stops passing those coupon payments back, the budget deficit gets worse, even without a move in rates.

To be clear, these realities are not the hallmark of cyclical problems, but structural. The Fed is not going to end its game voluntarily.