Proof the Fed Can’t Print Money
When former Federal Reserve Chairman Ben Bernanke announced to the world the Fed was going to purchase U.S. Treasury debt and mortgage-backed securities, one of the first questions he was asked was if the Fed was printing money. Ben repeatedly stated that the Fed was not printing money.
This bond purchase program, called Quantitative Easing, was an existing policy tool of the Fed, but they were not printing money, even though to the average American it looked like they were. In the years that followed, the Fed would conjure nearly $4 trillion under Quantitative Easing 1-3, but they didn’t print one penny because the Fed does not have the tools nor the ability to print money.
The Fed came into existence when Congress passed the Federal Reserve Act of 1913. In 1937, Congress amended the Federal Reserve Act to allow the Fed to purchase “direct obligations of the United States.” In this one page amendment, there is one sentence granting the Fed this ability:
Provided, however, That until June 30, 1939, the Board of Governors of the Federal Reserve System may, should it deem it in the public interest, upon the affirmative vote of not less than a majority of its members, authorize the Federal Reserve banks to offer, and the Federal Reserve agents to accept, as such collateral security, direct obligations of the United States.
In future amendments, the 1939 date was pushed back, and as far as I can tell, removed. “Direct obligations of the United States” is any debt of the United States. The act of buying U.S. Treasury debt is not printing money because the Fed is limited to only purchasing government debt. In 1978 the Federal Reserve Act was amended again:
Substituted “any obligations which are direct obligations of, or are fully guaranteed as to principal and interest by, the United States or any agency thereof” of “direct obligations of the United States.”
The 1978 amendment allows the Fed to purchase mortgage-backed securities that are insured by Fannie Mae and Freddie Mac, who guarantee both principal and interest payments on all mortgages they insure.
The Fed has the ability to purchase U.S. Treasury debt and mortgage-backed securities with money they conjure out of thin air, but the Fed lacks the tools and the ability to create money. The Fed has no control over the money multiplier, or “little m.” The Fed can purchase debt and use their policy tools to encourage borrowing and lending, but they can’t force the banks to lend or the public to borrow. Money can only be created through the banking system, which the Fed regulates, but doesn’t control.
The money multiplier is the amount of money banks generate from each dollar of reserves. The money multiplier is currently 3.8, meaning banks generate $3.80 for every dollar in reserves, which is down from its pre-Great Financial Crisis peak of 8.95.
The Fed had several objectives for Quantitative Easing which started with recapitalizing the failing banks by transferring their non-performing mortgage-backed securities to the Fed’s balance sheet for U.S. Treasuries. The Fed then lowered short-term interest rates by swapping long-term bank-held U.S. Treasuries for short-term U.S. Treasuries. To boost asset prices, the Fed bought U.S. Treasuries back from the banks for cash. The Fed’s hope was the Fed’s hope was that banks would start lending again which would increase the money supply through the money multiplier.
The Federal Reserve Act Amendment of 1937, unless repealed, makes the money multiplier algebraically defined: M2 Money Supply (M2) = Monetary Base (MB) * money multiplier (m). The Fed has the power to raise and lower the Monetary Base, and raise and lower the Federal Funds rate, but unless the money multiplier responds, the M2 Money Supply, or bank credit, may not move in the direction the Fed wants. For this reason, there is no direct relationship between the money supply and the Fed’s balance sheet, which is which is further evidence the Fed does not have the ability to print money.
The Fed was hoping Quantitative Easing would increase inflation to their 2% target, but they have remained perplexed as to why inflation remains relatively low. The reason inflation remains low is because Quantitative Easing boosted asset prices, which is not inflationary. Inflation comes from money printing, which you now know the Fed is unable to do. The low growth rate of the M2 Money Supply since the Great Financial Crisis confirms the Fed is unable to print money.
In December 2015 the Fed announced they would begin raising the Federal Funds rate and in October 2016 the Fed announced they would begin selling off the bonds they purchased during Quantitative Easing 1-3, and for some reason, the world saw this as inflationary. Raising the Federal Funds rate is a policy tool the Fed uses to decelerate the growth-rate of the money supply. Selling the bonds from their balance sheet is not inflationary because buying those bonds was not deflationary. Selling the bonds from their balance sheet reduces the Monetary Base (MB) and also decelerates the growth-rate of the money supply.
We know the reduction in the Monetary Base (MB) will decelerate the growth rate of the M2 Money Supply (M2) because the money multiplier (m) is not increasing fast enough to offset the decrease in the Monetary Base. The money multiplier is a function of the number of Commercial Banks, which has dropped from a high of over 14,000 banks in the mid-1980’s to less than 5,000 today. With fewer Commercial Banks in the system, money cannot multiply fast enough to offset the Fed’s reduction in the Monetary Base.
The facts have not kept the Fed and the American public from getting worked up over inflation. The Fed follows a flawed economic theory called the Phillips Curve that suggests there is an inverse relationship between the unemployment level and inflation. When inflation is low, as it is now, the belief is inflation will rapidly rise as newly employed workers increase their borrowing. As borrowing increases, money is then multiplied by the banking system which causes inflation. The Phillips Curve is flawed because the number of employed has no correlation with inflation. The Phillips Curve is only valid when a low unemployment rate is matched with a corresponding increase in the money supply.
When the Fed began raising the Federal Funds rate and selling off their bond holdings, they unknowingly embarked down a path of monetary disaster. The Fed is deliberately decelerating the money supply with the belief that inflation is about to take off. If the Fed is wrong, they will drive the economy into a recession at a time when the global economy is the most over-leveraged it has been in history.
Traders, investors, hedge fund managers, and speculators are quietly hoping for another financial crisis, or at least a downturn in the economic data – anything which might cause the Fed to reinstate Quantitative Easing and lower interest rates. Wall Street knows the Fed cannot print money, but the Fed can increase asset prices. With Wall Street in the business of charging fees against asset prices, higher asset prices are good for their bottom line.
Some Fed officials have said they would support reinstating Quantitative Easing if the conditions warranted it. The Fed may have no choice to, even if there isn’t strong public support for it. When credit bubbles burst, asset prices plummet and financial systems crumble. The Fed may be forced into Quantitative Easing to re-inflate asset prices and recapitalize the banking system just like they did following the Great Financial Crisis.
Many Americans are worried that countries like China, who holds $1.187 trillion of U.S. Treasury debt, will dump our bonds onto the market which will cause interest rates to spike. Americans need not worry because the Fed has the ability to purchase all outstanding U.S. Treasury debt should the need arise. Such a move will have other consequences, but at least the Fed could purchase our debt.
While the American public and Congress remain suspicious of the Fed, it is important to understand that under the Federal Reserve Act Amendment of 1937 and its subsequent amendments, the Fed is only authorized to purchase U.S. Treasury debt and mortgage-backed securities. The Fed does not have the legal right to purchase stocks, futures contracts, real estate, corporate bonds or any other asset. Congress could pass a law allowing the Fed the privilege to buy those assets, but for the time being, they cannot.
Now you know the Fed can only raise and lower the Monetary Base and the Federal Funds rate, but unless the money multiplier or bank credit responds positively, the Fed can’t print money. Until the Federal Reserve Act of 1937 is repealed, the Fed lacks the tools or ability to print money.
Q&A with Steve – Your Questions Answered
- What happened to the stock market on Monday?
Equity markets worldwide jumped on renewed threats of a trade war. I don’t understand how trade wars can be bullish for stocks, but apparently many people think so. Trading volume on the largest S&P 500 ETF was dismal. The last time it was this low was right before Christmas last year when the markets closed early for the holiday. Why stock prices continue to rise on such low volume is beyond me. Volume this low is an indication of a lack of buying interest.
The DJIA tried once again to close over its 100-day moving average which has been a source of overhead resistance since April and failed. Maybe market participants will continue to try to push it higher, but if they fail, the 200-day moving average will be the next spot of support for markets to test.
Over the weekend data came out showing Speculators have doubled-down on their Treasury bond shorts bringing short interest to a new record low. As expected yields rose, but not nearly as much as they should have based on the record short positioning. Asset managers are buying bonds as fast as Speculators are selling.
Sugar and Cocoa sold off heavily which drug down all soft commodities. I can’t find any specific news as to why, so it was either a technical move because neither Sugar or Cocoa broke through their overhead resistance or it was due to trade war fears. Volume wasn’t overly heavy and I expect buyers to come back into the market quickly as prices fell back into a 10-month long “Buy Zone.”
Gold is still hovering just below $1,300/oz. Sentiment on gold is in the toilet, which suggests a buying opportunity is near. The large gold mining ETF failed to get past its 100-day moving average for the fifth day in a row. I expect further price weakness and for it to drop into our “Buy Zone” in the near future.
- What happened to the stock market on Tuesday?
It was another low volume day for the major indices with the Nasdaq-100 forming a potential double-top. For those who follow technical analysis, a double-top is a strong sell signal. We should know in the next few days if this is a double-top or just a break of the previous high. The DJIA attempted and failed to move upward through its 100-day moving average, which is a sign of weakness.
Factory services data come out today suggesting a 3.5% GDP growth rate for the second quarter. With record short interest on 10-year Treasuries, one would expect yields to be breaking out to new cycle highs. The bond market doesn’t agree with the growth projections. Keep in mind, the bond market is usually more right than the stock market, except when there is record short interest.
10-year Treasury yields hit the bottom end of the overhead “Buy Zone,” where bond buyers have been buying and failed to break higher. Momentum hasn’t turned to trigger my move to bring cash it, but it’s very close.
Agricultural commodities dipped again but found buyers in mid-day trading. I am beginning to think this was a stop-loss run against weak longs or people who bought but put tight stop-losses on. China announced they are willing to buy more of our agricultural commodities if the Trump administration is willing to cool off on starting a trade war. With an anticipated record heat wave coming to the Midwest and southwest, crops are likely to be damaged which should lead to higher agricultural commodity prices by the end of the year.
The large gold miners attempted to break over their 100-day moving average but failed again. At some point, sellers will push this into our “Buy Zone.”
- What happened to the stock market on Wednesday?
Around 11:15-30am PST, in what was a purely technical move, the S&P 500, Nasdaq-100 and DJIA broke out of their overhead resistance and moved higher. The reason this is a technical move is that there wasn’t any news released around that time to trigger a buying frenzy.
Bond yields ticked up in overnight trading. Some traders I follow have been saying yields needed to go a bit higher and they did. There was buying action in late trading, which shows investors are buying bonds.
Agricultural commodities found a little life today with buyers stepping in. Looking at the weather report over the next two weeks, there will be lots of heat coming to areas where there are newly planted crops. There is a bit of rain the in the forecast, but not much. If the heat damages the crops, that will lead to higher prices.
Physical gold is showing a major warning sign of an impending “Death Cross,” which occurs when its 50-day moving average pierces downwards through its 200-day moving average. The last time this happened, gold fell rapidly. This is a good sign for us, as it suggests gold could fall to my target “Buy Zone.” The large gold miners finally moved over their 100-day moving average, but without physical gold confirming, this move should be short-lived.
- What happened to the stock market on Thursday?
While most people reading this probably don’t care much about the Brazilian economy, troubles there caused some minor issues in the markets today. Things in Brazil are likely to worsen.
Equities looked poised to capitalize on yesterday’s gains with investors regaining their bullish swagger.
Treasury yields opened higher but quickly fell in early trading before the flash crash in Treasury bonds sent yields down sharply. The Brazilian Real is tumbling, and it experienced a brief flash crash which caused Treasury yields to crash as well. The Real recovered slightly, and yields ticked up in late trading.
Treasury bond prices are starting to rise as downward momentum is bottoming. Volumes are strong, which is a good sign of a pending trend reversal.
Physical gold can’t seem to get past $1,300/oz and has been holding that price level for a couple weeks now. The large gold miners fell below their 100-day moving average but managed to close just above it. There’s no sign of strength here.
Agricultural commodities seemed to be positively correlated with the U.S. Dollar and appear to be leading moves in the dollar. Commodity prices fell and closed a “gap” between the opening and closing prices going back to April 4th and 5th before finding buyers. If the correlation between agricultural commodities and the dollar is valid, it suggests agriculture prices could rally ahead of the dollar rally I think is coming.
- What happened to the stock market on Friday?
Not much in the news today. Asian and European equity markets were down and global risks are on the rise. U.S. investors aren’t too concerned as corporations continue to buy their stocks back which is propping up the stock market.
Bond yields were down in overnight trading but closed flat for the week as investors continue to hold their record short positions.
The big risk is next week with the Fed meeting where they will likely raise the Federal Funds rate. Higher short-term interest rates are not good for stock investors, but you won’t know that by looking at a price chart.
Physical gold remained at $1,300/oz where it’s been for the past month. Large gold miners fell below their 50- and 100-day moving averages, which is a sign of weakness.
Agricultural commodities saw strong buying today as prices moved to the top of what has been a strong “Buy Zone.”
Special Momentum Update –
One of my goals was to create a rotational strategy using annual momentum. The strategy would apply the annual momentum formula to a large number of equity, bond and commodity ETFs. Once I cracked the code on momentum, I shared with you the two strategies using the S&P 500 and Nasdaq-100 with the annual momentum algorithm applied that showed incredible back-tested returns. But there were two challenges keeping me from creating a rotational strategy.
The first was creating a proper weighting algorithm, which I kept running into roadblocks on. Fortunately, Morningstar® shared with me their formula which I was able to adapt for my purposes.
The second was more challenging. For anyone who is an Excel expert, this is probably easy, and while I’m quite adept at Excel, I’m not an expert. What I needed to do was pull data from about 60 individual spreadsheets and consolidate them on to one spreadsheet by row. Not easy, but I finally got it. From there I needed to take that data and consolidate it into another spreadsheet with a format compatible with the Morningstar® Direct platform.
Due to a large amount of data, this seemed somewhat impossible to automate, but I came up with a system as automated as possible. I have to pull in data for about 40 or more ETFs and finish building out the system. It’s very time consuming and monotonous.
I’ve run several tests as I go to make sure it works. After facing repeated rejection while building these strategies, I’ve become pessimistic when running the back-tests.
I’m am excited to share with you that the first four or five tests I’ve run were very successful. They didn’t generate the outsized returns the Nasdaq-100 annual momentum strategy did, but they are generating near 15% annualized returns by rotating in and out of the sectors showing either positive momentum or an upturn in momentum. It is super cool!
Linked below in your e-mail is a “Multi-Asset Annual Momentum Prototype” Investment Detail report for you to review. As I get more data in and run more back-tests, I’ll share with you the results. This could open the door for more specific strategies, such as ones focused on growth, value, commodities or bonds. I also want to test other momentum timescales, which should be somewhat easy once I get all the data inputted.
Nonfarm Payroll and the Birth-Death Model –
The BLS reported 223,000 jobs were created in May. What they didn’t report is how many of those jobs were due to newly formed businesses, or people who became self-employed. I hope you’re sitting down… According to the Birth-Death Model which estimates (it’s completely made up) the net number of self-employed showed that 215,000 of the 223,000 jobs created last month were from newly formed businesses. Meaning the actual number of jobs created was 8,000. Data provided by the Bureau of Labor Statistics.
Portfolio Shield™ Update –
The June 2018 Morningstar® Investment Detail Report is linked below.