The chicken and egg debate regarding the Fed-in-a-box theory contemplates which comes first, rising interest rates or selling bonds back into the economy and to banks.

I have discussed that there are too few bonds in the system to act as collateral for deals and derivatives. But it is proving very difficult to sell bonds to the big banks or to “other financial institutions”, as the big banks have a really good deal, interest on money in the excess reserves they possess. They get less interest on bonds if they purchase them. The “other financial institutions” may be holding out for a better deal on bonds. They could even be colluding to boycott bonds.

So, the issue of trying to raise interest rates when there is the risk of deflation is a real risk. And deflation is threatening us, as many others have pointed out, from all sides, financially, globally, and technologically. Yet the other financial institutions want to buy bonds more cheaply.

The Fed is fooling itself if it thinks there is not a deflationary pressure on Main Street. There is. When you consider student loans, payday loans, easy money car loans and new easy mortgages, there is a definite pressure towards deflation. Main S treet is only deleveraging by walking away from loans and not by paying down many loans.

Main Street pays on interest and doesn’t spend on the economy, which needs to grow. It is growing a little, but not because of any big wealth effect, only by the borrowing and debt effect.

Raising interest rates in this environment is pretty hard to do. The Fed can bypass the big banks by selling bonds in the repo market to other institutions like hedge funds, but it has to raise rates and lower the price of the bonds in order to promise the hedge funds and small banks that it will buy the bonds back at a higher price.

So, the repo market could freeze up one day, aggravating the cold shoulder the “other institutions” are giving bond buying.

In a deflationary situation the Fed seeks to raise rates and lower the value of the bonds in order to get out of the debt trap. Raising rates is supposed to increase inflation and lessen the burdens of government debt and private debt. But the attempt to raise rates is being met with stiff resistance.

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