Berkshire Hathaway
Out of Control

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By rclosch
January 6, 2005

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In 2004 The Fed Raised short-term Interest rates five times, yet rates on 10 U.S. Treasury Notes actually fell, beginning the year at 4.25% and closing on 12/31/04 at 4.22%. Wall Street happy applauds, declaring that this is evidence that the FED has been successful in fighting inflation. Sir Alan has ridden to the rescue and finally and forever banished the inflation dragon, so that long-term interest rates will never again return to the levels that we witnessed in the 1980's and 90's. Yet, it seems to me that if the FED wants to control inflation they have to, at some point, be able to control the cost of shelter, which is of course the biggest share of the consumer's budget.

After all if the FED wanted to control inflation wouldn't they want mortgage rates to rise? In fact if they were really doing they job wouldn't they want to cool hosing costs more that the rest of the economy? This is the area were prices are rising the fastest.

Because of the trends in the bond market mortgage rates have remained low. The reason that long term rates did not follow short term rates as they moved up is not entirely clear, but I suspect that long rates are being driven more by the purchase of treasury securities by foreign central banks than by anything that the FED is doing. Recent auctions of treasury securities have seen as much as 60% of the securities going to foreign buyers.

While in theory I have nothing against these central banks subsidizing the American consumer's purchase of housing, low mortgage rates are feeding the housing bubble. The longer mortgage rates remain at present levels the bigger the bubble is going to get, and we all know, that the bigger the bubble gets the bigger the mess it will make when it pops.

It is not entirely clear to me what is driving the appetite of these foreign central banks for American Debt, particularly in light of the falling dollar. But it is possible that the Japanese bank in particular feels that the easiest way to simulate their domestic economy is to pump up the American consumer.

This disconnect between the FED tightening and the flat mortgage market suggests that perhaps the FED is no longer able to control the domestic economy to the extent that it was able to do in the Twentieth Century. So are we to the point that international money flows can short circuit FED policy? And if we are approaching that point what is going to happen if the dollar continues to weaken and the foreign buyers of our debt decide to move their money elsewhere?

We could develop a really scary scenario where foreign sales drive the price of our bonds down and long interest rates start to raise rapidly. What is scary about this is that there might be nothing the FED could do about it. They could try to loosen monetary policy and even drive short-term rates to zero. But as long as the foreign bondholders kept selling, long-term rates would continue to rise. I know very little about how the big boys play interest rate spreads, but it seems to me that the above scenario could blow these spreads completely out of their historic patterns, and introduce all kinds of stress into the derivatives markets.

Maybe that does not scare you, but it scares me.

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