FOMC: Forking Over More Currency?

Today’s FOMC meeting is largely a done deal. No moves, but sound hawkish. Personally, if I were in their shoes, I would move the Fed Funds target to 2.05%, just enough to weird the markets out, but not enough to do any real damage to those who rely on Fed Funds. Creating uncertainty through breaking the convention on quarter percent moves would be good for the market, because market players have gained a false confidence over what the Fed can and can’t do.

The thing is, the Fed is boxed in, like many other central banks. A combination of rising consumer prices, rising unemployment, and a weak financial sector will compel them to stay on the sidelines for now.

I received a number of responses asking me to explain my views. Here goes:

1) I’m not a gold bug; I have no investments in gold, or metals generally at present. Any liking that I have for a gold standard is that it gets the government out of the business of manipulating the economy through manipulating the money supply. Currency boards, pushed by my old professor, Dr. Steven Hanke, are another good idea.

2) Where am I on inflation/deflation? We are experiencing goods and services price inflation, asset deflation, and a monetary system where the Fed is not increasing the monetary base, but the banks are expanding their liability structures over the last year, but that may have finally peaked. Consider this graph:

There is a limit to how large the liabilities of the banking system can get relative to the Fed’s stock of high-powered money. We reached that limit in the first four months of 2008, and now banks seem to be focusing on survival.

It is very hard to reflate bubbles — you can’t build an economy on sectors that are credit impaired, which makes me think that the housing stimulus ideas will likely fail.

3) The Fed is in a box. They have no good policy options now. They are stuck between rising (or at least high) inflation, rising unemployment, and the banks are not strong. Fortunately the US Dollar has been showing a little more strength, but that’s probably anticipating the hawkish tone of today’s announcement. If the statement is insufficiently hawkish, I would expect the US Dollar to weaken.

4) I expect goods inflation to persist in a moderate way over the intermediate-term, unless the main US Dollar pegs are broken (Gulf States, China). Presently, we import a little of the inflation that the rest of the world is experiencing mainly through energy, and energy related commodities, like fertilizer.

5) Globalization does restrain wage growth on the low end. On the high end, it is likely a benefit, and in the middle, probably neutral. Those who benefit the most are those who are able to use relatively cheap labor for unskilled tasks. But technological change also affects job prospects in different industries. My view on steel is that the industry shrank mainly due to technological improvements at the lower cost mini-mills.

6) As for the GSEs, banks, and the investment banks, the Fed would be challenged to raise rates much. At present, the positively sloped yield curve is allowing some banks to repair by borrowing short and lending long. That is a good trade for now, but will be prone to trouble if the Fed ever concludes that it has to shift to fighting inflation, and not just put on a rhetorical show.

7) Finally, we have some degree of restiveness among the hawks on the FOMC. I would expect two (or so) dissents favoring tightening today, but now with the current cast of ten (counting Elizabeth Duke, a banker), if we get four, which is not impossible, I think it would unnerve the markets. Mishkin is leaving at the end of August, and the custom is that he attends but does not vote at his last meeting. (For more on FOMC dissents, I have this article.)

Well, let’s see what the FOMC has to say. After all, at present, they are all talk.

Comments

[JasonC:]

The Fed isn't in a box. It is just done. All they have to do is stand pat and let the huge spreads being offered to banks repair their balance sheets. Banks can borrow at 2-3% and lend on government guaranteed mortgages at 5.5%, or sound corporate credits at up to 7%. More speculative corporates at 8-9% still without any material risk of immediate default (e.g. major financials, REITs, etc - without touching the outlier financials, or autos, or airlines).

This doesn't even need to be lending particularly long. GNMAs have 5-6 years average life, 10 year corporates yield amount like those given above. If they want they can lend to A corporates at 2-3 years and still make 5% or more.

The only thing they can't make money on is all piling into short treasuries to take no risk at all. Which, of course, is what too many of them are doing, causing those wide spreads for everything else in the first place. Why are they doing so? To stay within their Basel II risk requirements. You don't need any capital as credit risk against treasuries, nor any for interest rate risk on short Repos. Their capital being impaired, they aren't lending for return but to minimize the capital adequacy analysis, impact.

But the first bank that extends itself at these spreads is going to make money hand over fist, and the rest will follow as that moves rates lower on the midrisk credits. Medium corporates are going to return double digits over the next 3-5 years e.g.

Do they need to raise rates instantly to quell inflation? No, there isn't any to speak of on the monetary side. Commodity bubbles will go smash of themselves if the monetary fuel is lacking. If they had to shovel out money with a firehose to keep short rates down at 2%, then maybe they'd have a problem. But they don't. Credit isn't moving at all.

The nearest analogy is the early 90s. Once rates were dropped to 3% back then, they did the trick, it just took a little time for the banks to earn out, for the SL stuff to all get liquidated, and the credit crunch to fade. It will be the same this time. Will they eventually need to retighten? Sure. But not for several year yet.

2008 Aug 05 01:19 PM

[bbzz24:]

credit is simply unavailable to anyone who cannot borrow directly from the fed. that is the reality. the rate cuts have not been passed on, they have been engineered to guarantee profitability of present leveraged mortgage holdings and loans (p/e, cre).
the whole banking world has come to realize that they've been lending to deadbeats lately. that is making them extremely cautious in the future and will be de facto a handbrake on the economy for quite some time.

2008 Aug 05 01:52 PM

[JasonC:]

Corporate bond issuance in May June and July totalled $221 billion. That is hardly credit unavailable. They are paying spread to get it, certainly, but credit worthy corporations can raise money as needed. Business credit and loans at all commercial banks stands $237 billion higher than this time a year ago.

Banks are earning spread and need to. Corporations can borrow if they have uses for the money that will actually pay, as in earn normal rates of return. The average corporation can't borrow at 2%, correct. But that isn't remotely the same as not being able to borrow.

2008 Aug 05 06:42 PM

[Lea Cabrerra:]

Of course the Fed is in a box. The arrogant money shufflers think they can defy the laws of financial physics (economics) but inevitably "money nature" has it way.

Their current stance reminds me of a couple of bank robbers who've barricaded themselves in a house after the calvary has finally caught up with and surrounded them. They've taken plenty of dollars hostage so there will be a lot of collateral damage when the final shootout takes place.

2008 Aug 05 06:44 PM

[GaryD:]

Jason, you are proposing that the banks borrow from the Fed and then loan to major financials(?). The major financials already have access to Fed money at prime. Why on earth would they borrow from other banks at 5 points over prime as you suggest? You also mention that loaning money to REITs has no material likelihood of immediate default. True, but since the banks won't be able to get these loans off their balance sheets anymore by packaging them into make-believe mark-to-fantasy bundles and selling them to clueless foreigners, they will need to keep that garbage on their own balance sheets, which will require them to set aside more capital, which they don't have, which is the problem in the first place.

2008 Aug 06 01:30 AM

[flow5:]

No the answer is the same as in 1966 where REG Q ceilings for the commercial banks were lowered but not for the financial intermediaries (S&Ls).

The savings-investment process is an abstract reality that conceptually is unfathomable to the unthinkable (Just as Einstein’s early papers were).

2008 Aug 07 11:28 AM

[flow5:]

unthinkable = unthinking

2008 Aug 07 11:31 AM