Prechter: Why the Fed Will Not Stop Deflation

Editor's note: Robert Prechter's Latest Elliott Wave Theorist was released three weeks early, and is one of his best Theorist's ever. He does not mince words and cuts straight to the bone on what the Fed is and is not willing to do. It is fascinating reading. I have arranged to make this brief excerpt available.

Excerpted from The Latest Elliott Wave Theorist
August 26, 2007 | Robert Prechter

We hear it every day: "What about the Fed?" The vast majority of investors and commentators seem confident that the Fed's machinations make a stock market collapse impossible. Every hour or so one can read or hear another comment along these lines: "the Fed will provide liquidity," "the Fed is injecting money into the system," "the Fed will be forced to bail out homeowners, homebuilders, mortgage companies and banks," "the Fed has no choice but to inflate," "the government cannot allow deflation," "the Fed will print money to stave off deflation" and any number of like statements.

None of them is true.

The Fed is not forced to do anything; the Fed has not been injecting money; the Fed does have choices; the government does not control deflationary forces; and the Fed will not print money unless and until it changes its long-standing policies and decides to destroy itself.

A perfect example of one of these fallacies recently exposed is the widespread report in August that the Fed had "injected" billions of dollars worth of "money" into the "system" by "buying" "sub-prime mortgages."

In fact, all it did was offer to stave off the immediate illegality of many banks' operations by lending money against the collateral of guaranteed mortgages, but only temporarily under contracts that oblige the banks to buy them back within 1 to 30 days. The typical duration is 3 days. Observe three important things:

   1. The Fed did not give out money; it offered a temporary, collateralized loan.
   2. The Fed did not inject liquidity; it offered it.
   3. The Fed did not lend against worthless sub-prime mortgages; it lent against valuable mortgages issued by Fannie Mae (the Federal National Mortgage Association), Ginnie Mae (the Government National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation). The New York Fed is also accepting "investment quality" commercial paper, which means highly liquid, valuable IOUs, not junk

As a result:

   1. The Fed took almost no risk in the transactions.
   2. The net liquidity it provided -- after the repo agreements close -- is zero.
   3. The financial system is still choking on bad loans.
   4. Banks and other lending institutions must sell other assets to raise cash to buy back their mortgages from the Fed.

These points are crucial to a proper understanding of the situation. The Fed is doing nothing akin to what most of the media claims; like McDonald's, it is selling not so much sustenance as time, in this case time for banks to divest themselves of some assets. But in the Fed's case, that's all it's selling; you don't get any food in the bargain.

As I have said before, the Fed is a bank. It has private owners. The owners do not want to see their enterprise destroyed. Although Bernanke probably received distress calls from mortgage lenders, he probably also got calls from the Fed's owners saying, "Don't you dare buy any of that crap and put it in our long-term portfolio." The Fed's owners are smart. They exploit the banking system without taking on any of the risks. They let member banks make mortgages and lend to consumers, but they don't do so themselves.

In the early 1930s, as markets fell and the economy collapsed, the Fed offered loans only on the most pristine debt. Its standards have fallen a bit, but not by much. Today it will still lend only on highly reliable IOUs, not junk. And it doesn't even want to own most of those; it takes them on only temporarily as part of a short-term repurchase agreement.

The Fed's power derives from the value of its holdings, which are primarily Treasury bonds, which provide backing for the value of the Fed's notes. What would a Federal Reserve Note be worth if it were backed by sub-prime mortgages? The real value of U.S. Treasury debt is precarious enough as it is, but at least it has the taxing power of the government behind it. But if the Fed bought up the entire supply of sub-prime mortgages, its notes would lose value accordingly. So will the Fed bail out mortgage companies, as the optimists seem to think? No, it won't. Those who think the Fed will buy up junk with cash delivered by helicopter are dreaming.

Ironically, of course, the Federal Reserve System and the federal government-both directly and via creations such as privileged mortgage companies and the FDIC-have fostered all the lending and the junk debt that resulted. But these entities want only to benefit from the process, not suffer from it. As we will see throughout the bear market and into the depression, the Fed is self-interested and will not brook losses in its portfolio. Those who own the bad loans, and perhaps some foolish government entities that try to "save" them, will take losses, but the Fed won't. ...

What must the banks do with their "grace period" of a few days that the Fed's repo agreements provide? They have to raise the cash to buy back the IOUs that the Fed agreed to hold for them. How does a bank raise money? By selling assets. Thus begins the downward spiral: Contracting credit causes asset sales, which cause collateral values to fall, which causes lenders to curtail lending, thus contracting overall credit, which causes assets sales, and so it goes. Thus, the Fed is not staving off deflation; at best, it may have helped -- momentarily -- to make it more orderly. But the selling of assets has begun regardless.