Bill Gross: Expect Fed Funds To Hit 3.5%

From PIMCO Managing Director Bill Gross's monthly market commentary for November 2007:

[B]oth old-fashioned banks and their derivative, conduit-fed shadow counterparts will be growing their balance sheets a lot more slowly in future months and quarters. That rather immediately translates into a slower economy and the need for government assistance in the form of lower interest rates or liquidity pushes like Treasury Secretary Paulson’s “Super SIV.” Whether Paulson’s “Committee to Save the World – Part II” will succeed like Bob Rubin’s original during the Long Term Capital crisis is debatable. The idea, first of all, is counterproductive because it continues to hide subprime asset prices in the “shadows.” Secondly, Rubin confronted no regulatory headwinds back in 1998, nor did he have to deal with today’s behemoth shadow banking system in the process of losing its brave face. Rubin in fact, along with his all-star committee featuring Alan Greenspan and Larry Summers, had a near hurricane force tailwind with 24 months more of dotcom IPOs yet to come. No wonder that Chairman Greenspan needed to cut short rates by only 75 basis points before stabilizing the economy nearly a decade ago.

Ben Bernanke has no such luxury. While he does have the backstop of a global economy powering on at a 4-5% annual clip, today’s U.S. IPOs were more a creation of leverage and the shadow banking system’s ability to create productivity gains through finance, as opposed to technological innovation. With banks and their shadows in retreat and modern day “world saving committees” relatively impotent, Bernanke must do some heavy lifting as opposed to the light housework required of Alan Greenspan in 1998. An increasingly recessionary looking U.S. economy will likely require 1% real short rates and 3½% Fed Funds in order to stabilize a potential growth contraction in lending not witnessed since the early 1970s or, to be honest, Roosevelt’s depressionary 1930s. We can only hope that Bernanke, Paulson, and their cohorts recognize the danger and that the music keeps playing with the lights still turned on.

Comments

[erniem:]

Gross has made more than a few bad calls lately, this is one more. The fed is DONE lowering rates until the inflationary pressure is relieved. Hidden inflation is SO rampant in this country, there is almost a reality disconnect. The core inflation index is a joke.

2007 Nov 04 12:14 PM

[Bob K.:]

Maybe so, but the Central Banks will sacrafice inflation fighting to delever this credit bubble, by allowing the banks to steepen the curve and to allow the NGO's of housing Fannie, Freddie and such to refinance these home loans. Purchasing power be dammed

2007 Nov 04 12:29 PM

[johnthebear:]

You are wrong in not addressing the bleak situation in European countries.

The economic conditions in most European countries is now experiencing a sharp downturn in consumer spending and confidence. There is a housing bubble in most countries as serious as here in the USA, but you would never know if from the media. They have not reported the falling house prices, nor the declining construction spending etc. The residential construction portion of the economy will crash and soon.

There are already major bank failures in England and Germany and the banks in Spain, Greece and Italy are all suspect as well as most European countries. Several have asked for central bank help and this will increase, just as it is here.

Therefore, to say that all is well in the China and India markets is not true. You have written about their bubbles in great detail. But once European stocks tank, and this could begin Monday, watch out. These bubbles could all unwind really fast.

2007 Nov 04 10:53 PM

[globalview99:]

We are going into the second leg of the most robust economic expansion in history due to the convergence of free trade (product, service & capital), the internet and rise of democratic power. There are of course imbalances due to overextension (energy and the sub-prime mess) which are in the process of correction but it is just the gears grinding as the global economy shifts into second gear.

The Fed may set target rates for various funds but its the global capital markets that set the real rates. In this scenario, the Fed's role really reverts to its classic role, the lender of last resort rather than setting proactive economic policy. In this capacity, it performed ideally in the recent credit crunch.

Now the credit markets are de-leveraging and unwinding in orderly fashion. Its sort of like when a football has been fumbled and the players on the field lose their poise and go crazy trying to recover the ball; and the end result is always the same: grown men throwing themselves on, over or under a pile of bodies hoping to save the day. Eventually, the referees after repeated attempts by blowing whistles, throwing flags and shoving these huge guys to one side or another finally gets everyone to stay put and slowly one by one bodies come away from the pile. Eventually the ref finds out who has the ball and signals who has possesion and the game gets back on track and everyone regains their poise. This is what's happening now with behemoths like Merrill and Citi emerging from the pile (they fumbled the ball and are coming up empty) indicating huge losses and of course heads rolling. There'll be a few more while the indicators (GDP growth, employment, inflation, etc.) will signal that the overall expansion is still on. Everyone will regain their poise, the doom and gloomers will go back in the closet and the capital markets will rise again and second leg of this expansion will drive the indices into new territory.

As the old Neill Young song goes "don't let the sound of the wheels drive you crazy".

2007 Nov 06 12:04 AM

[Sr. Pessimist:]

3.5% won't do the trick. An economy without US Dollars would do the trick. Transacting seashells from mermaids' chests, or raw equity vouchers, where if you have nothing to offer you have nothing to receive in return. I'm talking to you, upper class.

2007 Nov 06 03:07 PM