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Strategies & Market Trends : The Epic American Credit and Bond Bubble Laboratory -- Ignore unavailable to you. Want to Upgrade?

To: el_gaviero who wrote (33182)	5/25/2005 5:34:12 PM
From: Tommaso	Read Replies (2) \| Respond to of 110194

As I understand it, banks' reserves must consist of actual cash plus deposits measured as cash with the Federal Reserve. There is a category of "secondary reserves" that consist of investments in United States bills and bonds, which (I suppose) can be sold to meet the basic reserve reqiruement. But the bonds and bills do not count as or work as money, and do not allow the creation of money that the entire banking system (not a single bank) makes possible. Therefore, the fluctuation in value of the bonds has no direct effect on the money supply. The fluctuation is caused (or is the inverse of) the interest rates, which for the long term bonds are largely a measure of expected future inflation. Here's Prechter's sentence again (the additions in brackets were mine): "Fearful holders of suspect long-term debt far from expiration [i.e. long bonds] could dump their notes and bonds on the market, making prices collapse [i. e. prices of those bonds]. If this were to happen, the net result of an attempt at inflating would be a system-wide reduction in purchasing power of dollar-denominated debt, in other words, a drop in the dollar value of total credit extended, which is deflation." (130) The "dollar denominated debt" that he speaks of would certainly lose value as inflation fears increased and interest rates rose. The holders of this debt would be the victims of the inflation (they always are). They would lose a lot of their real wealth. The holders of real assets become wealthy at the expense of holders of long term debt. The holders of bonds were not planning to spend that money that they tied up in bonds. They meant to have the income and then get their money back. I realize that this is an oversimplification and I know that bonds are continually bought and sold, but to imagine and describe every contingency is beyond me here. Mostly, buyers of long term bonds are aiming at safety and income. Prechter is constructing a perfectly absurd argument that says that inflation is really deflation because the prices of long term bonds fall. The Fed does not control long term interest rates, except to the extent that its policies create or restrain inflation. It can buy and sell bonds, but the amount of debt is so huge that the buying and selling affects the money supply a lot more than it does interest rates. All sorts of additional fiscal, monetary, political, and psychological variables feed into this process.