8 Notes About The Fed

by: David Merkel, CFA

1) Let’s start out with my forecast. I’ve given it before, but it has become the conventional wisdom — at the next FOMC meeting at the end of April, the Fed will cut by 25 basis points. They will make the usual noises about both inflation and economic weakness, as well as difficulties in the financial system, and comment that they have done a lot already — it is time to wait to see the power flow.

The only difficulty is whether we get another blowup in the lending markets that affects the banks. We could see Fed funds below 2% in that case, but absent another crisis, 2% looks like the low point for this cycle. Now all that said, I think the odds of another crisis popping up is 50/50. We aren’t through with the decline in housing prices, and there are a lot of mortgages and home equity loans that will receive their due pain.

2) One interesting sideshow will be how loud the hawks will be opposing a 25 basis point cut. We have comments from voting members Plosser and Fisher already. Price inflation is a real threat to them, and one that is closer to the Fed’s core mission than protecting the financial system.

3) Okay, give the Fed some credit regarding the TSLF, which is now almost not needed. The TAF is another matter — there is continuing demand for credit there. It will be interesting to see when the Fed will stop the the TSLF, and what happens when they try to unwind the TAF. As it seems, some banks still need significant liquidity from the TAF.

4) Indeed, if the Fed is lending to investment banks, it should regulate them. I would prefer they didn’t lend to investment banks, though. Better they should lend to commercial banks that are negatively affected by investment bank failures, and let the investment banks fail. After all, there is public interest in the safety of depositary institutions, but I’m not sure that if the investment banks disappeared, and the commercial banks were fine, that the public would care much. It certainly would teach the investment banks and the investing public a real lesson on overdoing leverage.

5) Okay, so LIBOR rises after it seems that some bankers have been lowballing the rate in an effort to show that they are not desperate for funds. Significant? Yes, the TED spread has widened 12 basis points since then. I’m sure that borrowers with mortgages that float off LIBOR will be grateful for the scrutiny.

Having been in similar situations in the insurance industry regarding GIC contracts, I’m a little surprised that the BBA doesn’t have some requirement regarding honoring the rate quote up to some number of dollars. On the other hand, can’t they track actual eurodollar trading the way Fed funds gets done, and then just publish an average rate?

6) On to the last three points, which are the most controversial. You know that I think the core rate of inflation is a bogus concept. If you are trying to smooth the result, better to use a median or a trimmed mean, rather than throwing out classes of data, particularly ones that have had the highest rates of inflation. Given the inflation that is happening in the rest of the world, I find it difficult to believe that we are the only ones with low inflation, unless it is an artifact of being the global reserve currency.

7) I was quoted at TheStreet.com’s main site regarding the Fed. I think that the Fed is caught between a rock and a hard place, but I am not as pessimistic as this piece.

8) Finally, how do the actions of the Fed get viewed abroad? Given the fall in the US Dollar, not nearly as favorably as the press coverage goes in the US. Do I blame them? No. They sense that they are losing economic value to the US, and that they are implicitly subsidizing us. No wonder they complain.