10 Notes on Our Funky Federal Reserve

 |  Includes: DIA, SPY
by: David Merkel, CFA

1) Fed chatter has gotten a little quieter, so maybe it is time for an update. Let me begin by saying in an era of detailed press releases from the Fed, many analysts spend more time parsing phrases than looking at the quantitative guts of monetary policy. This article from Mish, which cites this article from Gary North is close to my views, in that they are looking at what is happening to the critical variables of the money supply.

2) For another example, Look at the discount window. That has faded as a factor over the past two weeks. You have to dig into Dow Jones Newswires just to hear about this. The discount window is back to being a non-entity.

3) Review his book. Cite his article. Though I think the FOMC will loosen more, I agree that it should not be loosening. The Fed will overstimulate healthy areas of the economy, while sick areas get little additional credit; that’s how fiat monetary policy works. (Maybe I should review James Grant’s The Trouble With Prosperity?)

4) I may not vote for him, but I like Ron Paul. He is one of the few economically literate members of Congress. Thus I enjoyed his question to Ben Bernanke. I favor a sound dollar, and risk in our system. It keeps us honest. Without that, risk taking gets out of control.

5) Now, onto the chattering Fed Governors. Consider Donald Kohn, a genuinely bright guy trying to spin the idea that the Fed is not to blame for residential real estate speculation. He argues that much of the speculation occurred while the FOMC was tightening. Sorry, but the speculation only cut of when the FOMC got rates above a threshold that deterred speculation because positive carry from borrowing to buy real estate disappeared, which finally happened in September of 2005, when the FOMC was still tightening.

Or, consider Fed Governor Frederic Mishkin, who thinks that troubles in the economy from housing can be ameliorated by proactive FOMC policy. If his view is dominating the Fed, then my prediction of 3% fed funds sometime in 2008 is reasonable.

But no review of Fed Governor chatter would be complete without the obligatory, “Don’t expect more rate cuts.” They don’t want their policy moves to be impotent, so they verbally lean against what they are planning on doing. This maximizes surprise, which adds punch to policy moves.

6) Consider foreign central banks for a moment. I’ll probably write more about this tomorrow, but a loosening Fed presents them with a problem. Do they let their currencies appreciate, slowing economic growth, or do they import inflation from the US by cutting rates in tandem? Tough decision, but I would take the growth slowdown.

7) What central bank has had a rougher time than the Fed? The Bank of England. When push came to shove, they indicated that they would bail out a large portion of the UK banking system. Northern Rock financed a large part of their assets via the Bank of England during their crisis. This just sets up the system for greater moral hazard in the future.

8) Now the CP market is returning to health; almost all of the questionable CP has been refinanced by other means. Now, money market funds are better off than they were one month ago, but all of the issues are not through yet. Some money market funds contain commercial paper financing subprime CDOs. Now, the odds are that the big fund sponsors would never let the ir funds break the buck. They would eat the loss. That’s not a certainty though so be aware.

9) This article is the one place where the Fed lists most of the Large Complex Banking Organizations [LCBOs — pages 32-33]. Some suggest that this is the “too big to fail list,” though by now, it is quite dated. On the bright side, it correlates highly with asset size, so maybe a list of the 20 largest bank holding companies in the US would serve as well.

10) We end with Goodhart’s Law, which states that “any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.” My way of saying it is that trying to control a system changes the system. The application here is that when the Fed tries to affect the shape of the yield curve by FOMC policy, it eventually stops working.