Don Miller (Money Morning):
The U.S. Federal Reserve may take an unorthodox approach to raising interest rates by paying interest on bank reserves rather than relying on traditional open market remedies, as it exits from its long-term fiscal stimulus programs, Reuters reported today (Tuesday).

Paying interest on reserves is mostly untested and would represent an unexpected twist in the Fed’s response to the financial meltdown.

“In the old days … the Fed controlled the federal funds rate with open market operations,” Antulio Bomfim, a former Fed economist now with Macroeconomic Advisors LLC in Washington told Reuters. “Now, at least in this period when reserves are over-abundant, the way the Fed hopes to raise the federal funds rate will be primarily by raising the interest rate it pays on reserves.”

Usually, when the central bank wants to set a target for the federal funds rate it buys or sells Treasury securities on the open market, influencing interest rates by deploying or withdrawing capital.

By paying interest on reserves, the Fed makes it attractive for banks to keep their money at the central bank as long as interest rates in private markets are lower.

By doing that, the Fed can put a floor under the lending rate that banks charge each other for overnight loans, which is the central bank’s traditional choice for influencing the economy. Open market operations to raise interest rates would be relegated to a supporting role in the initial stages of tightening.

In order to spark an economy mired in deep recession . . . Click here to read the rest of Mr. Miller’s article.

This from Taipan Daily:

“Widespread property foreclosures have led to bank failures, and further to much unemployment and a disastrous decline in manufacturing and agricultural production.” Sound a tad familiar?

No, it is not another of my dreary “ripped from today’s headlines” quotes. Rather, it is a contemporaneous description of the chain of events that lead to, and resulted from, the Panic of 1819.

And while the storyline may be some 189 years old, the circumstances are eerily familiar. Washington (the place, not the man – our first president had passed away 20 years earlier) had borrowed heavily to finance the War of 1812, severely depleting bank reserves.

Free Money and Real Estate Bubbles, 19th Century Style

To cope, Washington and Wall Street did what they have done so many times since: they simply changed the rules. This time around they suspended specie payments – a complete violation of depositors’ contractual rights.

With the onerous restriction of actually repaying debt with real coin lifted, most every ambitious soul with a pen and a checkbook rushed into the banking business. The sudden increase in the “money” supply encouraged the most insane sort of speculations (real estate being a particular favorite).

Soon, the whole deal was snowballing out of control. When the Second Bank of the United States finally tried to take away the punchbowl, this hollow economy collapsed in on itself… leading to the aforementioned 1819 crash.

A Haunting Refrain

As you can see, today’s dire warnings of market collapse and recession are not quite as unique as we might hope. Rather, they are simply the latest refrain in a long, long (long) ballad.

Cold comfort, perhaps, to know that our forefathers were just as inclined as we toward such feats of over-stimulation, overextension, and excess speculation. Still, there is some comfort to be found reading through our long tale of financial foolishness.

Over the past 210 years or so, we have “enjoyed” 17 recessions, lasting anywhere from a few months to more than two decades. While the worst, the “Long Depression” of 1873-1896, lasted some 23 years, the average duration has been a mere four and a half years.

Damned Modernism

Now don’t go reaching for the bourbon just yet. We’ve put all sorts of systems in place since those bad old days. Many of you like to curse the day in 1913 that saw the birth of the US Federal Reserve, and are wont to describe Fractional Reserve Banking as “the tool of the Devil” (or at least Joe Stalin).

Damned or not, these institutions do exist. One could even argue their arrival on the scene marks the beginning of our “Modern Economy.” If we were to restrict our list of recessions to said “modern” period only, the average breakdown is reduced to just under three years.

Now dial the clock forward again. If one were to begin counting with the day in 1971 that Richard Nixon finished off the remaining tatters of the gold standard, the average duration of recessions is reduced to a year and three quarters.

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Rounding Second and Halfway Home

The history may be a tad twisted, but my point here is straightforward enough. While there is certainly no guarantee that we could not invent a way to extend our little debacle another year or six, the odds are that we are already a third – if not halfway – through “the crisis of 2007-2009.”

Which brings us to what I like to call the “Window of Serenity.” Near-term, things do still look quite dreadful. And long-term, I have no doubt that we are embarked on the path of monetary ruin described so exquisitely by the Austrians.

But if you look in the middle, beginning some 18 months out, one can see where the ramp-up to the next major bubble ought to be taking place. The question is: how do you navigate the choppy waters between here and there?

How to Stay In the Game

Once again, I have to tell you that mere “trading stops” won’t work. If that’s the limit to your methodology, then perhaps you really ought to just sit things out until the next cycle is obviously underway.

But what if you are intrigued by the values that are out there (and I will grant that the survivors of this current trough are apt to double many times over come said ramp-up – especially in its earliest days)?

If that’s the case, then there is only one tactic I know of that will allow the safe accumulation of shares in current circumstances. And that is the careful matching of put option contracts on weak players to share purchases of strong players.

Buying Survivors

For example: Let’s say you wish to invest in a venerable old retailer like Macy’s (NYSE:M), currently trading under $10 for the first time since 1995.

Heck, they’ve been around in one form or another since 1924, and have weathered seven of the recessions on my list. That fact alone reassures you that they ought to still be here in another 18 months.

Now, I’m not saying you’re right or wrong with this trading theorem. But I can tell you how to survive Macy’s going to $5 while you find out.

A Cure For the Pain

Simply buy some put options on a real deadbeat low class player like, say, Kohls (NYSE:KSS). While Macy’s shares were getting cut in half over the past few weeks, select Kohl’s puts gained as much as 200%.

Your gains on Kohls’ pain become your safety line against losses on Macy’s shares. Heck, you could even use your profits to buy more shares.

These are admittedly hard times, friends. Fortunes are being lost daily. But situations like these, when everyone else has their head buried in the sand, are possibly the most potentially lucrative trading set ups you will ever see.

Source: How to Make 200% a Month Handicapping Recessions

In that ad hoc comment, we wrote: “The crux of the thesis of our latest book, The End is Not Nigh, is simple and goes something like this: a) Asian central banks continue to manipulate their currencies and prevent them from finding a fair value against either the US$ or the Euro b) this manipulation triggers an accumulation in central bank reserves which, in turn, leads to low real rates around the world c) the combination of low global real rates and low Asian exchange rates amounts to a subsidy for Asian production and Western consumption d) in the US, the subsidy has by and large been captured by individual consumers e) meanwhile, in Europe, the subsidy has been cashed in by governments whose debt has skyrocketed f) we see little reason why, in the near future, the subsidy should be removed but g) if it were removed, the US would most likely encounter a consumer recession (not the end of the world) while h) Europe could go through a debt crisis (far more problematic).”

We went on and wrote: “Last week, and against most observers’ expectations, the Indian central bank did not raise rates at its meeting. Instead, it seems that the authorities are allowing the currency to rise and hopefully thereby absorb some of the country’s inflationary pressures (linked to energy and higher food prices). In recent weeks, the rupee has shot higher and now stands at a post-Asian crisis high. And interestingly, the local market is loving it. While Indian stocks had been sucking wind year to date, the central bank’s apparent policy shift (from higher interest rates to higher exchange rates) has triggered a very sharp rally.

This of course is an interesting turn of events and we would not be surprised if Asian central banks were to study developments in India carefully over the coming quarters. After all, India is blazing a path that a number of Asian countries may yet decide to follow.

One could argue that a change in monetary policy in Asia could end up being a “triple whammy” for Western economies. It would mean that:

• Asian central banks would export less capital into our bond markets and this would likely lead to a drift higher in real rates around the world.
• Asian exchange rates would move sharply higher, which in turn would likely mean higher import prices in the US and Europe.
• As Asian exchange rates start to move higher, Asia’s private savers would likely start repatriating capital, further amplifying exchange rate and interest rate movements. This would also likely lead to collapses in monetary aggregates in the Europe and the US.

Finally, we concluded the paper by saying: As we highlighted in Part 1: Why We Remain Bullish, we are not worried about valuations. And we are also not worried about “excess leverage” in the system, or the threat of a “private equity bubble”. We also do not fear an “economic meltdown” or a brutal end to the “Yen carry-trade” (which we did fear in the Spring of 2006). Instead, if we had to have one concern, it would have to be a possible change of monetary policy across Asia and the impact that this would have on real rates around the world. As we view things, the only reason Asian central banks would change their policies is if food prices continued to increase (in that respect, owning some soft commodities — a hedge against rising real rates — makes sense to us – as does owning Asian currencies). Interestingly, such a turn of events seems to be unfolding in India, yet no one seems to care. Monitoring changes in Asian inflation, monetary policies and exchange rates could prove more important than ever.

Nine months after that paper, we have indeed just gone through a period of a) rapidly rising food prices which have led to b) faster inflation rates across Asia, which have triggered c) a change in Asian monetary policy, notably a willingness to let the currencies appreciate faster than they have in the past. And if Asian central banks are now finally allowing their currencies to rise, then one thing is sure: Asian central banks will no longer need to print large amounts of their own currencies and accumulate US$ and Euros. They will thus also no longer need to buy US Treasuries and European bonds to the extent that they have.

Is it a co-incidence that, as Asia starts to allow its currencies to rise, US mortgages have been hitting the wall and spreads amongst European sovereigns have started to widen? The subsidy that Asian central banks have been giving to consumption in the US and governments in Europe (see The End is Not Nigh) is now disappearing.

Indeed, for the past five years, spreads of Italian ten-year government bonds to German bonds have hovered between 15bp and 25bp. But recently, spreads have started to break out on the upside.

And, of course, Italy is not alone. All across Europe, we have seen a widening of spreads between the “stronger” signatures (Germany, Holland, Austria, Finland, Ireland) and the “weaker” signatures (Portugal, Italy, Greece, Spain, Belgium, France) including those of Eastern Europe (Latvia, Romania, Hungary, Poland…).

In the US — arguably an epicenter of the modern global monetary system — I see a central bank whose powers are constantly expanding. This progression dates back to its birth in 1913, but as recently as 1999 and 2003, parts of the Federal Reserve Act were rewritten and the Fed was given more power to create money.

Today, with progressive calls for action in the face of crisis, the Fed’s tentacles are potentially reaching directly into the credit and securities markets. This week alone, the headlines are rife with news of its “sweeping” new powers under Treasury Secretary Hank Paulson’s “plan.”

The Federal Reserve is in the midst of another historic interest rate-cutting campaign. Its official policy stance is that it recognizes the inflation risks, but worries more about growth, so it will inflate to sustain “growth.”

Money’s growing on trees

Its message has been, more or less, that money grows on trees, which is why Ben Bernanke’s moniker, “Helicopter” Ben, is catching on with the press. Gold bugs could not be more thrilled. Just recently, I wrote that we are seeing the best of all worlds for gold to shoot straight up a few hundred points.

But wait! “It’s not such a sure thing.” At least that’s what I thought I heard…from a voice in the wilderness. “What do you mean it’s not a sure thing? Look at ‘em flood the markets with liquidity. $100 billion here, a few hundred there.”

As I was about to sign off, the voice continued: “No, they are not inflating. They’re just creating confidence in the credit markets. Look at the ‘money’ numbers,” said the voice. “Forget credit. Look at the level of bank reserves and the adjusted monetary base. They haven’t grown since August. The Bernanke Fed is just pretending to inflate!”

Disinflation?

Perhaps I already knew what the voice was telling me. Like the title character in Tolstoy’s classic novel, The Death of Ivan Ilych, I was doing some soul searching and discovering hidden truths buried deep beneath the surface. The voice was my own, and it was telling me something I had yet to consider.

It has not escaped my attention that the narrow constituents of money supply are not expanding. I’ve written about it.

This disinflation was first apparent as far back as 2005, under Alan Greenspan’s tenure, when M1 growth hit zero percent on a year-over-year basis. He set it in motion through the rate hike campaign. The total value for US M1 has not changed in three years. But our “voice” insists that Bernanke is running a different, more deflationary policy than Greenspan — even though under Bernanke’s reign, since 2005-06, the broad credit aggregates have reaccelerated and the tightening campaign abandoned, and reversed. Clearly, the Bernanke Fed is running a different policy.
But it is difficult to call it a more deflationary one.

Bernanke’s Fed

Okay, so it has kept M1 flat, and slowed the growth in the monetary base a wee bit further (which has no doubt contributed to the crisis). And since August, the Fed has not expanded bank reserves overall, even though it has slashed its policy-setting interest rate by 300 basis points, has taken other measures to ensure short-term liquidity and talks as if it is ready to underwrite almost any insolvency.

We may point out that if the Fed wanted deflation, it would have already arrived. If, for example, Bernanke actually did nothing, the monetary base would have probably shrunk.

At a minimum, the Fed is inflating just enough to replenish erosion in bank reserves and the market’s confidence. The thrust of all of its actions has been to cheapen money and credit and inflate.

That is not to say there aren’t any deflationary forces in the system — just not ones produced by the actions of the Federal Reserve System so far. If there is deflation in the system, stable money proves the Fed is inflating. If it were pursuing a deflationary policy, you’d have seen a few more Bear Stearns by now — and it is unlikely that the broader credit aggregates like M3 and money with zero maturity (MZM) would be expanding so furiously.

Sure, there is a run on risk, and this risk aversion is causing some asset deflation, which in turn is producing a lot of short-term liquidity. So the Fed hasn’t had to create a lot of net new notes to push rates down, yet. Consequently, so far, it is merely underwriting a lot of the market’s current confidence, rather than monetizing it. But it does not necessarily follow from stable money supplies that the Fed is deliberating a deflationary policy.