Inflation, Rates and How the Sausage was Made

Due to Covid, the Fed made the decision to to invest in mortgages in order to save our economy, stabilize our housing market and protect people's health by keeping them at home in their homes.?They cut rates and bought all the conventional agency mortgages we could manufacture.?As a result, the mortgage industry kicked into high gear, hired many tens of thousands of people creating an army of refinancers,?and refinanced TRILLIONS of dollars in mortgages.?We reduced people's payments and we provided them with cash by tapping into their equity. People had cash to spend.?And they did!?And everyone felt great.?Woo Hoo! MISSION ACCOMPLISHED!

Wait,?here's the thing - that's not the end of the story.?There's this expression about not wanting to know how the sausage is made...

When you refinance a loan, you pay off whomever owned the previous loan.?Newsflash - it probably wasn't the Fed.?Moreover, the Fed didn't use money they had saved up for a rainy day - they used SOMA and the Fed's fictitious balance sheet.?Which basically means they signed an IOU to the American People.?Better stated, they created the money out of thin air.?They used that funny money to pay off most all the previous debt holders.?Which means they manufactured trillions and trillions of dollars and handed it out like candy to the investors who owned the MBS securities which were all paid off.?Yep, spoiler alert - the Fed created the very inflation they are now trying to curb.?But as everyone is finding out, it's not that easy to put the genie back in the bottle, toothpaste back in the tube, cow in barn, pick your metaphor.?All those trillions of dollars are still floating around chasing too few goods. 8.5% INFLATION. (We'll discuss the "too few goods" issue in a different post.)

What's the solution??Raise rates of course!?Well not so fast... The Fed has $9 Trillion dollars on their balance sheet.?Roughly $4T is in low interest rate mortgage loans.?Volcker - er, sorry Powell has publicly said he wants to shrink the balance sheet.?But the higher rates go, the less likely it is that any borrower will pay off those low rate loans early.?That means the average duration of each of those bonds is getting longer and longer.?As bond yields increase with rate increases, and as duration lengthens because homeowners don't pay off their loans - the discount to sell off these MBS securities gets bigger and bigger.?Stated differently, nobody wants to buy the mortgages at low rates when the new ones are paying higher rates and the borrowers certainly don't want to pay off those low rate loans either.?So raising rates has the paradoxical effect of locking trillions of dollars of excess cash INTO our economy thus exacerbating inflation.?And the Fed's balance sheet is becoming worth less and less. If we did a mark to market, the American Public should do a margin call on the Fed! Head scratcher, right?

Ever played with one of those weaved finger traps as a kid??The harder you pull the more it tightens.?What's the winning move??Don't fight it - work with it.?Relax and use it against itself.

What does that mean??Everyone keeps referencing Volcker and the 80's.?But those were very different times.?Inflation was FAR worse than we're experiencing today - pushing 15%.?And it was caused by different circumstances. Moreover, there are other better options now than we had 40 years ago.?First let's talk about who really gets hurt with rising interest rates - it's the people that need to borrower money.?It's people who have big credit card balances.?It's people who can no longer qualify to purchase a home for their family.?Riddle me this - who are the majority those people??You guessed it - they aren't the billionaires and the tycoons.

What's the alternative to this shock and awe approach where they drop napalm bombs on the economy to put out a brush fire? Simply undue what they did to cause it in the first place! Liquidate the balance sheet at whatever discount it requires.?That will have the effect of sucking trillions of dollars out of the US economy.?Wall street would love to buy up MBS securities at a discount and that would serve to sequester those dollars. Yield would start to come back down. Rates will stabilize. Housing values will continue to rise. Everybody wins except the Fed who takes a big loss on their balance sheet. But does that really matter? It's all funny money any way which they created with a simple ledger entry and an IOU to you and me.??