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Declaring Victory Too Soon?

by: David Merkel June 10, 2008 | about stocks: RKH / XLF    
David Merkel

David Merkel

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The last few months have seen a change in expectations of FOMC policy. The next expected move is a tightening, while some incremental loosening was expected 2-3 months ago.

One of the reasons for this is that the Fed has managed to calm the short term lending markets. They have also managed to defuse a possible crisis among derivative books by bailing out Bear Stearns with the aid of JP Morgan. Also, GDP growth hasn’t gone negative yet, at least the way the Government calculates it. As a result, Ben Bernanke feels that the risk of a substantial downturn has receded, and so, the next focus of the FOMC will be inflation.

Now, I don’t think the answer for the Fed is that simple. That said, there are many that would welcome a tighter FOMC policy.

  • China is importing our lax monetary policy, and they are unsuccessfully trying to fight the implications of the policy, because they won’t raise their exchange rate. They will have to eventually, perhaps after the Olympics, but a tighter US monetary policy relieves some of their stress.
  • Europe would welcome a tighter US monetary policy, because it would relieve pressure on the rising Euro. As it is, the ECB with its single mandate is moving to fight inflation. Even the Bank of England is not loosening aggressively, and their housing problems may be proportionately greater than those in the US.
  • The Gulf States would like a stronger US Dollar to help arrest the inflation that they are importing.
  • Savers in the US might like higher rates.

But the trouble is that there are still weak spots that might cause the Fed, which has a dual/triple mandate to not tighten monetary policy. (Dual — inflation and unemployment. Triple — financial system solvency, inflation and unemployment.)

  • The Fed is not out of the woods yet on real estate related credit. I commented many times at RealMoney that Home Equity Lending would be a big problem, back in 2006. I also warned on option ARMs. Well, both are looming problems now.
  • This will lead to problems in the regional banks. Many of them are exposed.
  • I still expect residential real estate prices to fall further.
  • The correction in commercial real estate prices has only begun.
  • Also, investment banks are still delevering and taking writeoffs. Lehman is the most recent poster child there, but other investment banks could still be affected.
  • Beyond that, we have defaults rising in speculative grade credit, which will do damage directly, and through the CDOs that they are in.
  • Places like the Philippines may be canaries in the coal mine — they may be experiencing outflows of hot money at present.

I think the Fed has less freedom to act than is commonly believed. As Yves Smith has commented at his blog, the Fed may have painted itself into a corner. I think the risks from inflation, unemployment, and financial system weakness are fairly well balanced. As it stands, the Fed has adopted the following policy:

  • Don’t let the monetary base grow. Sterilize all new lending programs.
  • Allow the banks freedom to expand their lendings; informally relax regulations for now.
  • Bail out any significant systemic risks.
  • Work out kinks in the short term lending markets through new programs.

The Fed may make some of those new programs permanent, but then they will need to find a new policy equilibrium involving greater tightness elsewhere in their policy tools. They will also need to decide what to do regarding investment bank leverage, both direct and synthetic. They will also have to figure out what comes first if there is a broader banking solvency crisis, and/or significant shrinkage of real GDP with a rise in unemployment.

It is my guess that Dr. Bernanke is talking a good game today, but that the Fed’s policies will be loose toward inflation, should systemic risk or unemployment prove to be more difficult problems than currently advertised today. They are not out of the woods yet.

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This article has 13 comments:

  •  
    Jun 10 02:51 PM
    The FED has indeed painted herself into a corner in a weird room.

    For example what would happen if the interbank rates would go higher 100 basis points?
    Look at this debt detail of the latest Federal Reserve Z1 release and add up the relevant total columns (for the Federal debt you better use the debt ceiling from the Senate or Congress, Federal debt is far above the Z1 statement of 5+ trillion). Link:

    www.federalreserve.gov...

    You see; total debt is above 50 trillion.

    So in case would tighten in order to fight inflation and they start raising the lowest rates there are, after some time lag all other rates follow. Only rare debt like 30 year constant rate would not be affected.

    But 100 basispoints on over 50 trillion amounts to 500 billion US$ of extra interest every year...
    And that is 3 times the whole Dubya stimulus package (the stimulus package is also borrowed money by the way).

    And if you withdraw the new debt from 2008 Q1 from the GDP you arrive at minus 5% for economical growth.

    The long term strategical mistake the FED has made under Alan Greenspan was thinking they could postpone a recession with debt debt and more debt. But total debt always grew at a multiple of GDP growth hence this will all end in disaster.
    Reply
  •  
    Jun 10 04:17 PM
    Correction: With the 'minus 5% for economical growth' I mean in detail:

    Q4 2007 included debt growth, compared with
    Q1 2008 excluded debt growth.

    So it would be more honest to say: About 5% of the US GDP is borrowed money.
    Reply
  •  
    Jun 10 04:27 PM
    The key is Congressional behavior which will be profligate to the utmost during the next Congress. The Fed does not matter because it is toothless in the face of our employment/inflation paradox. But Congress? They may make the whole thing intractable with a series of new taxes on businesses and spending that will exceed revenues by a factor of 2 annually. All that we are doing is smoking before the hanging.
    Reply
  •  
    Jun 10 10:27 PM
    Reinko,

    Where do you get that Govt debt is over 50 trillion?
    Reply
  •  
    Jun 11 12:56 PM
    The Debt to the Penny and Who Holds It
    www.treasurydirect.gov...

    Federal Deficit
    06/09/2008
    5,307,821,153,547.15 - Debt held by the Public
    4,099,396,300,824.69 - Intra-governmental Holdings
    9,407,217,454,371.84 - Total Public Debt Outstanding
    Reply
  •  
    Jun 11 01:34 PM
    The FOMC has been following an extremely easy monetary policy (since Nov 06). You simply can't assume that the economic fraternity understands their discipline. They don't know what "money" is. They don't know what a financial intermediary is. They don't know how to measure aggregate demand (the housing market's performance revealed that).

    But in this case Friedman had it right "INFLATION IS ALWAYS AND EVERYWHERE A MONETARY PHENOMENON." It's about the math. Whether it is one transaction or the sum total of all transactions that encompass gdp, the math is the same: MV=PT And it works likes Planck's consant in physics (6.62607x10 power of-34 joule-seconds), i.e., monetary flows (MVt) occur at constant intervals.

    Since people follow the conventional wisdom, they will never arrive at a correct answer. There is no conspiracy, but some of the evidence was erased, though not enough to hide reality. If economists understood what they were doing we wouldn't have the problems that exist.

    The evidence for an easing is glaring. Obviously the evidence is politically incorrect.
    Reply
  •  
    Jun 11 01:55 PM
    Reinko is right. Total gov't debt - including offsheet - is more than $50 Trillion. Paulson has repeated this in his speeches. $10 Trillion is just the most direct borrowings.
    Reply
  •  
    Jun 11 02:10 PM
    The money supply can never be managed by any attempt to control the cost of credit - (Greenspan's held the 1% FFR too long Jun 03 - Jun 04).
    Reply
  •  
    Jun 11 02:19 PM
    Employment is not a mandate that the Fed can control
    Reply
  •  
    Jun 11 02:44 PM
    "Sterilize all new lending programs" The "trading desk" does not and can not "wash out" legal reserves (bank lending capacity). Reserves are no longer binding:

    See Richard G. Anderson Vice President & Economists --- Federal Reserve Bank of St. Louis

    "There is general agreement that, for almost all banks throughout the world, statutory reserve requirements are not binding. Banks need central bank deposits for clearing checks and making other interbank payments, which gives the central bank leverage over money and bond markets."
    Reply
  •  
    Jun 11 05:22 PM
    To Alex G and Doug:

    I only use the Federal Reserve detail from the Z1 release, link again:

    www.federalreserve.gov...

    Plus the latest ceiling in allowed Federal debt as put forward by the Senate and/or Congress.

    So the 50+ trillion is:

    US Federal debt +
    US financial sector debt +
    US corporate non financial debt +
    consumer debt like mortgages, HELOC, credit cards and so on.

    The trillions of borrowing against social security is not included and this is all non GAAP stuff. So no future obligations in it.

    Look for yourself in the one last column of the above FED file:

    Debt of the US financial sector only is above one GDP (and, just like all other debt lines, is growing at a multiple of the GDP).
    Reply
  •  
    Jun 11 10:57 PM
    @Reinko:

    Can you pls explain to me why use that 4 debts you mention? and us fed debt already contains debt by the pubic? can you enlighten me pls
    Reply
  •  
    Jun 11 11:25 PM
    Hey Doug, show me the Govt off-sheet.

    Reinko, if you are comparing USA to other countries or regions, you need to show their full statistics as well. Emerging markets don't count, as they don't give shit to the masses, as the developed countries do.
    Reply
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