Bill Gross: Fed Will Be Fixated On Housing For 'Next Several Years'

From PIMCO Managing Director Bill Gross's monthly market commentary (emphasis added):

Remember those old economics textbooks that told you how a $1 deposit at your neighborhood bank could be multiplied by five or six times in a magical act of reserve banking? It still can, but financial innovation has done an end run around the banks. Derivatives and structures with three- and four-letter abbreviations – CDOs, CLOs, ABCP, CPDOs, SIVs (the world awaits investment banking’s next creation; perhaps IOU?) – can now take a “depositor’s” dollar and multiply it ten or 20 times. Reserve banking, and the Federal Reserve that regulates the system, appear anemic in comparison...

Alan Greenspan admits in his newly published book that he didn’t appreciate until recently the impact adjustable-rate mortgages and their subprime character, accompanied in some cases by outright fraud, would have on the housing market. If the Fed was so slow to grasp the role that subprime mortgages played in the housing boom and bust, do the Fed and the Treasury of today totally comprehend what happens when the nonbanking private system suddenly stops flooding the market with credit? Do they recognize that such a shutdown puts spending for housing and business investment at risk, and job growth as well? The Fed will have to adapt its monetary policy, and the Bush Treasury will have to adjust its fiscal policy to this brazen new world dominated more and more by private rather than public policies and proclivities. To overcome private-market caution, the Fed may need to put on a bold face marked by even more decisive cuts in short-term rates. To prevent a housing-market slump from metastasizing into a cancerous self-feeding tumor, Treasury Secretary Paulson will have to coordinate policies that lend a helping hand to homeowners in distress...

PIMCO’s view is that a U.S. Fed easing cycle historically has required a destination of 1% real short rates or lower. Under a conservative assumption of 2½% inflation, that implies Fed Funds at 3¾% or so over the next 6-12 months. Actually that’s only two, 50 basis point reductions, something that could, but probably won’t, be accomplished by year-end. Don Kohn’s asymmetric elevator will likely be interrupted by false hopes of a housing bottom, fears of a dollar crisis, or misinterpreted one month’s signs of employment gains and faux economic strength. The downward path of home prices, however, will dominate Fed policy over the next several years as will the lingering unwind of related financial structures and derivatives that have yet to be discovered by the public, and marked to market by their conduit holders.

Comments

[Malkiel:]

The Brave New World's problems, beginning in the roaring '80's and exemplified by Milken, Enron, and New Century Financial, stem from having accounting, reporting, and information-handling standards that are too primitive for the complex nature of the modern markets. As much as the anti-government crowd in business hates it, the cure for the problem is government-imposed requirements codified into law, with input from business on technical issues. Sarbanes-Oxley is the latest example of how government has stepped in to provide the rules that no market player would otherwise be in a position to impose. The mortgage crisis will result in more government regulation forcing lenders to adhere to prudent practices in the application process; conservatives will gripe, but the market will be a better place for having rules and that segment of the economy will stabilize and be less likely to hurt the economy in the future. The value that government regulation adds to American markets by stabilization of business practices is the dirty secret that few dare speak out loud...

2007 Oct 02 05:44 PM