Fed's Recent Actions Have Been Lame

About a million years ago, I worked on the foreign exchange desk at the Federal Reserve Bank of New York. The position didn't pay very much, but it was a wonderful first job. I conducted market intervention, and supplied forex market intelligence to top-level U.S. monetary officials. I witnessed, first-hand, the formulation of U.S. policy during the turbulent times of the early 1980s (when the prime rate was north of 20%!!)

I cannot speak highly enough of the people at the Fed. They are smart, dedicated, under-appreciated, and woefully underpaid. However, like most human beings, they are prone to significant errors of judgment, particularly at key turning points...

IMHO, the Fed's actions over the past month or two have been lame, and somewhat bizarre. I simply do not understand their obsession with inflation when 10-year notes are yielding below 4%, and when major financial institutions are crumbling before our very eyes. The current subprime/mortgage/credit market crisis is difficult to solve, but 25 basis point cuts, and $20 billion, two-week repos, are simply not going to get the job done.

The fact of the matter is, ex-subprime, the credit market cycle is just BEGINNING to turn down. In most categories, default rates are still at historic LOWS. In other words, things will likely only get worse from here. And given the unprecedented degree of leverage in the financial system, I think this is highly dangerous.

Inexplicably, Mr. Bernanke seems to be following the incrementalism of his mentor, Mr. Greenspan. Greenspan responded to the credit crunch (again, real-estate related) of the early 1990s with a series of 25 basis point cuts, stretched out over 2-3 years. Sound familiar? The result was unnecessary pain, a change in the Presidency, and a jobless recovery.

Some of the Fed statistics that I like to watch, such as the monetary base and total Fed credit, indicate that the Fed has NOT injected permanent reserves into the system over the last several months. In other words, the Fed has lowered rates, but they really have not eased yet. Like Nero, they are literally fiddling as Rome burns.

If I were running the show, I would take the federal funds rate IMMEDIATELY to 3%, jam short-term liquidity into the system, and restore a positive (200-300 basis points) yield curve... only then can the system regain its footing, and resume lending. By the way, in conjunction with this policy, I would also say that this was the full extent of the rate cuts, for at least 6-12 months. Not only would this demonstrate that the Fed is interested in restoring growth into the financial system, but it would also silence the weak dollar/inflation hawks.

I do not expect this Fed to take such bold action, at least not in the near term. Rather, we will probably get more and more days like today... weak data and a weak market... a protracted crisis that causes unnecessary pain, and only forces the Fed to eventually cut more than they wish.

Until the Fed acts, really acts, it is difficult to be constructive on this market. The financial, consumer discretionary, and small-cap sectors are all arguably in bear markets already. My portfolio is very conservatively positioned, and will probably remain so for some time.

I am particularly concerned about this coming earnings season. Many companies are facing the lethal combination of flagging demand and higher input prices. I fear that many managements will, in effect, thrown in the towel and report kitchen-sink type of quarters. Eventually, this may be a positive, but the near-term could be difficult.

The good news is, the Fed will eventually panic... and may well set us up for a nice market in the second half, if not sooner.

Comments

[robert99:]

Ahh... Another inflationist. Even though I'm very heavily invested in gold, I am glad you are not in Ben's shoes. He knows the dangerous waters he is tip toeing through, and if he inflates the money supply too fast and it DOESN'T keep the economy from seeing negative growth, we could be in for some nice stagflation. I think he's trying to keep us out of that, and though I am very critical of the FED in general, I think he's doing a decent job of it.

2008 Jan 03 08:52 AM

[flow5:]

It isn't within the power or responsibility of the Federal Reserve to hold unemployment or even Gross Domestic Product to "tolerable" levels. In fact, to assume that the Federal Reserve can solve our unemployment problems is to assume the problem is so simple that its solution requires only that the Manager of the Open Market Account buy a sufficient quantity of U.S. obligations for the accounts of the 12 Federal Reserve banks. This is utter naivete.

2008 Jan 03 02:06 PM

[flow5:]

The discount window, before coming a penalty rate in 2003, was an emergency method of short-term funding at a mark-down from the FF inter-bank market-based interest rate. Previously, discount window borrowing was excessive, not shunned. Bernanke has the power (when he decides it's necessary) to reliquefy or prevent bank-credit contraction as a consequence of the CBs depositor's with-drawls.

2008 Jan 03 02:08 PM

[flow5:]

What should be done? The solution? As a long-term proposition, the Federal Reserve should re-apply and then gradually lower REG Q ceilings until the commercial banks are out of the savings business. Outside of the commercial banks, interest rates would be left to the market place. What would all of this do? The commercial banks would be more profitable - if that is desirable. Why? because the source of all time deposits is demand deposits directly via the currency route or through the commercial banks undivided profits accounts. Money flowing "to" the intermediaries actually never leaves the commercial banking system as anybody who has applied double-entry book-keeping on a national scale should know. The growth of the intermediaries cannot be at the expense of the commercial banks. And why should the banks pay for something they already have? I.e., interest on time deposits

2008 Jan 03 02:09 PM

[AQR:]

Why is the title of this post different from the original post at Vestopia.com?
www.vestopia.com/Blogs...
Who changed the title and why?
Why not leave the integrity of the author's origninal work intact?

2008 Jan 04 01:43 AM

[jay joffe:]

Hi Larry,

been a while since we've spoken (1981).

Interesting article, but the Korean system would be better. Centralizing the economy can only work for the richest. And they only make their money off of the poorest and the rich who sucker the poorest.

New model is called for. Common defense, prevention of starvation and civil war and leave everything else alone.

Mar 14 08:24 AM