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Graph 8
Bubbles don't deflate. They burst.
Aware of those risks, the Federal Reserve wishes to redress the situation by removing the proverbial punch bowl. However, it can only use its favorite tool - the interest rates - at the margin. [3] Anything else would likely have dire consequences on the economy. It would worsen the budget deficit, push some small businesses and households into bankruptcy, raise the value of the dollar and further deteriorate the nation's trade deficit while sending a harmful message to the stock market. A higher dollar would also raise havoc on emerging nations loaded with dollar denominated debts.
Faced with such unpalatable outcomes, the Federal Reserve opted for a softer approach. It chose to sell "reverse repos" [4] to drain excess cash from the system, and quietly contain the stock market folly. As of June 18, it sold $747 billion of "reverse repos", in effect cancelling over 6 months of quantitative easing - the easy money that is responsible for the market extravaganza it is now trying to tame. While this is a salutary move, it is unlikely to have much effect in an economy awash with cash. Banks' excess reserves total $3.8 trillion, seven times the reverse repos sold.
The Federal Reserve knows it is caught in a quagmire. There is little it can do at this point other than pray for long term interest rates to stand still despite the fact that inflation is looming. Fortunately for the Fed, the market agrees with its analysis: the 10-year Treasury dropped 20 basis points to 1.37 since Jerome Powell's Press conference of June 16th. In truth, no one knows how to get out of this mess. The economy is caught between a powerless central bank, an exuberant stock market, and an overindebted government. Investors and speculators are on edge - after dropping slightly in early June, the Dow Jones and S&P recovered. Every operator stands ready to jump off ship at the first glitch, whatever it may be - financial, social, economic or political, domestic or international - a glitch which may cause a panic and a crash, taking the economy - the world economy - along with it. When could this take place? It's anybody's guess. Anytime soon? Possibly.
[1] Let's recall that the primary objectives of the Federal Reserve are full employment and price stability (Employment Act of 1946 and Full Employment and Balanced Growth Act of 1978).
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