Fed Watch: The Genie is Out of the Bottle

Will the Fed cut the federal funds rate? Here's Tim Duy with his latest Fed Watch:

The Genie is Out of the Bottle, by Tim Duy: The Fed clearly does not want to cut the Federal Funds rate, especially in an intermeeting move. They are aggressively looking for alternatives, and pulled a rabbit out of the hat with Friday’s cut in the discount rate. And, as is widely known, this was not simply a symbolic move, made absolutely clear by the Fed’s urging of banks to use the discount window.

But did markets bounce on the discount rate cut, or the Fed’s statement that opened the door for a rate cut? I suspect the latter. The Fed effectively confirmed market participants’ expectations that a rate cut was coming sooner or later, and probably sooner at that. The genie is out of the bottle, and I suspect the Fed will have a hard time getting it back in.

Expectations are important. My expectation was that the economy was going to look weak going into the fall, and that there would be mounting pressure on the Fed to ease. But given the Fed’s resolve, and willingness to look through slowdowns, it was reasonable to believe they would hold steady through the year – and market participants pretty much agreed.

With the Fed statement, however, expectations are now turned upside down, with market participants looking for at least 75bp (intermeeting, September, and October, and maybe again in December) by the end of the year. Can the Fed turn those expectations around in a period of lackluster data, with the nadir of the housing market still ahead, even if the financial turmoil eases? Note that even as late as last Thursday, the Wall Street Journal was still writing:

A stubborn inflation rate along with stronger factory output could keep Federal Reserve officials wary of cutting interest rates despite the latest turmoil hitting markets.

As I noted Friday, the read on data is now decidedly negative. The Fed will not look at the dark side of each piece of data, they never do. I think that the Fed does not want to continue the crisis/ease/bubble cycle of the last decade. I believe they think this is becoming an increasingly dangerous game with inflation at the high end of tolerance. I think some are nervous that the productivity cycle is about to cut against them this time.

And I think that Bernanke & Co. have lost boatloads of credibility with the “subprime is contained” story. And that will make it difficult for them to sell the “housing is contained” story in the coming months.

As an interesting side note, I also believe that global central bankers in general are nervous that the liquidity creation of the last decade will soon come home to roost in the form of higher inflation. But if the Fed cuts, there will be pressure on other central banks to halt, if not follow suit with rate cuts of their own. Think of the pressure on the ECB to cut if the dollar slide against the euro as the result of a Fed rate cut…

Bottom line: The Fed does not want to cut the Federal Funds rate; they want to look through the slowdown. But they have now opened the door to a rate cut, feeding into market expectations for such a policy shift. Closing that door will not be easy.

Comments

[reason]

What amazes me is the size of the bounce we did get. How can small interest rate changes result in 5% plus changes in all asset prices, particularly when it is not obvious to me that the source of the problem is all that sensitive to interest changes (see for instance : http://news.goldseek.com/MillenniumWaveAdvisors/1187535944.php).

[Lafayette]

reason: What amazes me is the size of the bounce we did get. How can small interest rate changes result in 5% plus changes in all asset prices

Foolish expectations

Why assume that the relationship should be linear, or one-to-one? It's an emotional market out there. It does not obey the rules of reason. (No pun on your name intended.)

Like a wild beast, it has its own "logic"; which is not quite the right word for emotional behaviour, admittedly.

I suggest that what is happening is this: People, over the past two decades, have shifted from placing money in relatively safe (bank) savings accounts at nominal rates of interest diverting them to risky (and now volatile) market instruments. But, their mentality has not changed.

That is, they foolishly expect the regularity of the returns as in a savings account, but at higher levels. I call this, "Having your cake AND being able to eat it". Meaning, it is a process one step to far.

They are tripping over the character of higher returns, that is, their inherent risk. I suspect, in fact, that they are "betting the house" in a weird attempt at "getting it all now", thus featherbedding their future.

That is like taking dope. How could they have ever found the wisdom with which to believe it humanly possible? Because it isn't. It is somewhat like a Ponzi scheme, by which additional new money balloons market prices, which attracts more new money, until an unsustainable price level finally pricks the balloon.

Just like the dot.com boom/bust, this mess had from the very beginning the genetic makeup for its own destruction.

The rule of "diversification of investments" got warped. People diversified their equity investments, but did not realize that ALL such investments remain at risk. They move with the market. Diversification of investments meant diversifying fundamental risk, from lower to higher -- always maintaining a sustainable base in low risk investments (such as one's residence at low total mortgage).

When the economy is flush with easy money, it is also easy to be tempted to use it to aggrandize one's wealth. People have been burnt, yes, but they were playing with fire. One must presume they knew what might happen.