Is the Federal Reserve Ahead of the Curve?

The overwhelming sentiment of popular market pundits is that the Fed is out of touch and "behind the curve." (One of our hopes for 2008 is that writers will find some other phrases to describe this tired sentiment).

Other Expert Views

Fed policy has an effect with a lag. One way of examining this is to compare Fed action now with policy in past possible recession situations. This method is not used by those pundits whose overconfident view of the future leads them to data supporting what they already see as inevitable.

An interesting contrast is to look at observers who do make this comparison. Two of the very best in recent years have been Dick Green, the CEO of Briefing.com, and David Malpass, Chief Global Economist for Bear Stearns. We have frequently cited their comments.

Dick Green of Briefing.com has a consistent and sensible approach, that has demonstrated accuracy over several years. He writes as follows:

Enough data is now in to state conclusively: fourth quarter GDP will post a solid gain. That means the Bernanke Fed began cutting interest rates well ahead of significant economic weakness. Their early action will help prevent recession.

Green goes on to explain the basic rationale (but follow the link to read the entire article):

The Bernanke Fed has therefore cut the fed funds rate target from 5.25% to 4.25% even as real GDP growth was up at a 5% annual rate in the third quarter and a 2% annual rate in the fourth quarter.

Furthermore, the Bernanke Fed has taken strong efforts to provide liquidity to the banking system to address the problems in the credit markets. This is now starting to pay off. Credit growth has continued, as evidenced in the weekly H.8 data, and now the prices of mortgage-backed securities appear to be stabilizing, as reflected in the ABX derivatives contracts.

David Malpass has a similar view, with similar reasoning. Malpass still sees slowing growth, but rejects the notion of a housing-led recession. His recession odds have been lowered to 20% (which is actually the long-term average for a given year). Malpass wrote on December 21st as follows:

We think the Fed has been unusually proactive – it is now probably at or close to the end of its rate cuts, and will try to use other confidence-building techniques going forward. We think an expression of interest in a stronger dollar would be the most useful, but is unlikely.

This shows his view of the economy, but those wanting more rate cuts will find it discouraging. Malpass explains his reasoning:

We think the Fed has been distinctly more proactive than in past slowdowns. The Fed maintained high interest rates until the brink of recession in 2001 (Fed funds at 6.5% in early January 2001 with recession starting in March 2001) and into the recession in 1990 (Fed funds steady at 8% through October 1990, even though the recession started in August.)

The Fed acted earlier this time, and is also using innovative methods like the TAF auctions.

Many bears highlighted Malpass when he became more pessimistic earlier this year. Doug Kass, for example, called Malpass a "must-read." We are waiting to see what Doug and others say about Malpass's latest perspective.

Our Take

The assessment of recession prospects and the Fed reaction has been one-sided. Whether one reads the mainstream media, blogs, or watches financial television, the popular comment is that the Fed has not acted quickly enough. (If only we could collect royalties on "behind the curve.")

We have tried to emphasize that the Fed is attempting some creative tools in addition to cutting interest rates. Meanwhile, those who have long-standing recession predictions appear to be wrong once again this quarter.

There should be a statute of limitations on these forecasts. The key question for the investor and trader alike remains how much of the "baked in" earnings discount from a recession will actually occur.

Comments

[Reinko:]

The views as expressed in the article above are from out of this world.

According to the latest Z1 release 'flow of funds' the entire US financial started picking up debt in Q3 at a speed of over 16% of their entire debt position.

If economical conditions stay the same, the need 2.5 trillion US$ new debt a year. That is just 2500 billion but the 'help' some banks have gotten lately often amounts to only 5 to 8 billion.

As a comparison: 2.5 trillion amounts to the entire revenue that the US government took in...

So this will not turn into a recession but into a crash.

2007 Dec 26 11:13 AM

[Reinko:]

In case you want to check it yourself:

Here is the link to the Federal Reserve flow of funds:

www.federalreserve.gov...

2007 Dec 26 11:14 AM

[gordon:]

This is another attempt to claim we can REFLATE THE CONSUMER, when it is NOT the Fed's job to REFLATE an economy out of recession, but to protect the currency value. The USD hit 77 resistance, and is rolling over now, gold up,that is interference in the normal business cycle, which includes 1-3 yrs of retrenchment, where those who overleveraged are brought back to earth with the pain they deserve. Paulson thinks he can continue to funnel excess tax receipts to the broker-dealers, and they will continue doing what they did again ,today, look at a 1-day chart of the DIA, how they hit it with block buying at 1-1:30 pm, the lowest volume point of the lunch hr, again, taking the Dow from -60 to green. This is Plunge at work, for the White House, they will continue artificially infusing the DOW (DIA) and S&P (SPY) to "v" reverse any selloffs, so there is no base-building on the chart where a bottom is put in, this should be criminal interference in "FREE MARKETS". All those billions in repos given to banks for their toxic CDOs are not being loaned out, but instead the Treasury, aka Paulson ,relaxed the percentage of assets banks can give to their investment-trading operations, to funnel taxpayer or future borrowing into buying the Dow and S&P 500 , with these repo funds. We do not know what garbage -collateral the banks traded supposedly as a " LOAN", but these are being renewed every 2 weeks, rolled over , continually,by Paulson-Bernanke & Company.

2007 Dec 26 02:47 PM

[tntalk:]

Either way, the Fed or in reality, the society of bankers, always win in good economic times or bad. This is by their own design.

2007 Dec 26 04:56 PM