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Monday, September 10, 2007

Tales of market woe and pain: Blame the Fed

Immured from the real world – excuse us Sir, the markets are telling you something.

by StFerdIII



The so-called ‘housing bubble’ is a sorry prediction that is coming true thanks to gross incompetence and media mayhem. The incompetence lies with the US Federal Reserve – those august seers charged with killing inflation in the manner of Paul Volcker the Fed chairman who destroyed the stagflation of the 70s with 13% interest rates. The Fed reserve has a role to play – lender of last resort; arbiter of inter-bank interest rates; and printer of money which of course will impact rates and inflation. The Fed has a role, but doing nothing is not a role. It appears that the dapper men on the Fed Reserve board are full of models and hypotheses; not common-sense and energy.

The Fed created the housing ‘bubble’ or speculative excess. By having negative real rates from 2001 to 2004, and by printing money in excess of GDP and inflation growth the US Fed Reserve achieved two results; a declining US dollar and investment excess. Since credit was cheap and loans easier to obtain [a separate non-Fed related issue is the poor banking and lending practices by creditors], investments and spending increased. A fair percentage of this easy credit went towards loans to buy second and third homes, upgrade existing homes or buying undeveloped land in the hopes of being bought out by a developer. The Fed printed too much money and kept negative interest rates for too long. People took advantage and the great real estate gold rush was on.

Then the Fed went the opposite way and tightened too far, too fast. Interest rates went up 17 straight times by 25 basis points. Justified concerns about inflation and too robust economic growth led to the current level of 5.25%. But again the Fed did the wrong thing. Using past data the Fed built an interest rate model in which core inflation plus economic growth was well above 5%. What it did not do, was to forecast the decrease in economic activity due to higher rates; and the restraint on inflation due to globalised trade. By not forecasting properly the US Fed has produced predictably bad results and market turmoil.

In 2006 for example the Fed could have predicted that a 5% or so rate would impact and limit economic growth and that real inflation indicators excepting oil [cartel and subject to huge tax and regulatory costs] and cereal [subject to government subsidies, interventions, and the ethanol nonsense which drives up costs], would trend downwards as long as retail competition and increased trade existed. At that point in time if inflation data in late 2006 was 2.2% and economic growth for 2007 was forecasted to be about 2.5 %, the Fed interest rate should have been about 4.75% or 50 basis points lower than it is today. In fact during 2006 the Fed kept increasing rates and during May-July of 2006 the markets fell 5% recovering in a year-end rally running from October – December premised on global growth, strong US fundamentals and record corporate earnings. Those factors are now depreciated or in jeopardy. The Fed was wrong in 2006, and they are wrong in 2007.

It is clear that for about one year now the Fed reserve rate has been too high by ½ to ¾ a percentage point. This might not sound dramatic, but it is. By not lowering rates, the US Fed has increased the cost of money impacting homeowners, and corporations. It also negatively affects stock markets in which 2/3 of Americans have a stake. Equity markets react to poor Fed management and money will flow out of stocks and into Treasury bills, bonds, or secured debt instruments. Markets are not as dumb as the chattering classes maintain. Investors understand pretty quickly when something is wrong and react accordingly. It appears however that the Fed has ears made of wood [but nice silk suits].

They also are blind. The 91 day T-Bill rate is at about 3.25% which is telling the Fed that the market believes rates need to be cut dramatically. If the T-Bill rate is at this level, the message is clear – 5.25% is unsustainable and the market is both demanding and predicting a pretty dramatic fall in rates. The 91 T-Bill rate is a pretty good indicator of market sentiment, though it appears the Fed will ignore it. As well Bond rates are telling the Fed the same message – that short term rates are too high and have to be lowered. Again the Fed is ignoring the bond market.

The Fed’s task – to limit inflation is a pre-requisite for a well functioning market. Inflation is not currently a concern regardless of what the media drones on about. There are different levels of inflation – manufacturing, wholesale and retail. It is the last level that is the most critical. In certain markets there might be rampant manufacturing inflation [as cost inputs rise by large amounts] but at the retail level in a competitive market, much of this excess will be squeezed out. This is especially true in deregulated industries with limited government regulatory burdens [oil refining, food, airlines, banking, are examples where this does not apply].

Core inflation is about 2% - an acceptable level that shows little signs of increasing. US economic growth, thanks in part to lousy Fed policy is slowing to about 2% per annum. This means that the real interest rate should be 4% or 4.25% - a full percentage point lower than it is today. By lowering the rates the Fed would calm the equity markets; make credit available to qualified borrowers and businesses at lower rates; and end the housing speculation ‘bubble’.

It would also shut the media up. The most important part of a rate cut would be its media impact. The media has been negligent in first pointing out that negative interest rates lead to market distortions, and by not showing that current market signals are demanding a drastic rate reduction. Instead in good form, the media focuses on doom and gloom. But consider this. Even in the slime of sub-prime, 99% of mortgage payments are being made on-time. A financial meltdown, this is not. The mainstream media of course believes otherwise, fretting endlessly about the imminent collapse of the financial system even whilst most economic factors and even mortgage repayment numbers remain robust. Most media outlets ignore the real cause of the current ‘crisis’ focusing instead on the grandmother about to lose her over-priced, and super-mortgaged house, or Hillary Clinton’s bail-out scheme to repay speculative investors who played a bad hand and lost.

The Fed Reserve acting as a US central bank is a necessary and mandatory function in today’s globalised economy. What is less clear is how to control this system of last resort. Its mandate lies thankfully, outside of political control. But what to do when for 7 years now, we have a group of men ignoring market signals, market pricing and real economic data? Getting rid of the Fed is impossible and dangerous. But not recognising its weaknesses, advocating reform and trying to limit the damage it does to markets and individuals, is also purblind.