Fed Watch: The Fed's Next Move

Tim Duy is looking for clear signals about the Fed's next move and having trouble finding them:

The Fed's Next Move, by Tim Duy: Although the last FOMC statement did not commit the Fed to a policy direction, market participants expect Bernanke & Co. to keep cutting right through the New Year. With the stage set for the FOMC to increasingly discount inflation concerns as the housing market worsens, it is difficult to argue against that expectation. Of course, a labor report stands between us and the next meeting - but will it be enough to draw attention away from housing?

The case for additional rate cuts appears to revolve on the direction of housing and inflation at this point. Regarding the former, return to the most recent FOMC statement:

Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.

Should we be concerned then about housing or financial conditions? What if housing continues to collapse in the months ahead despite loosening credit conditions? For now, I think it is best to assume that the Fed, or a majority of policymakers, is no longer confident it can disentangle housing from financial markets. Consequently, I expect that housing activity will play a significant role in the Fed's forecast.

And that view of the economy is dismal, to say the least. I won't go into the details of recent housing data, leaving that to others such as Jim Hamilton and Calculated Risk. The upshot is that the situation continues to deteriorate, and it is likely that we are only seeing the beginning of significant price declines. Moreover, Fed rate cuts are highly unlikely to offer any support to housing; at best, the Fed can soften the impact of a declining housing market. Bubbles cannot be recreated. Like all bubbles, this one was based on the expectation that housing prices always rise. With that delusion shredded, the speculators are in the wind.

Regarding inflation, the official numbers are cutting in the Fed's direction. Friday's report on PCE is really cut and dry. Core-PCE posted three consecutive 0.1% gains, pulling the 3-month annualized rate to just 1.5% and the year-over-year rate to 1.8%. True, core-CPI is running at a 2.5% rate over the past 3 months, but, until we hear differently, the Fed prefers the PCE measure.

Housing down, inflation down. Given the Fed's recent behavior, case closed. More rate cuts are coming.

What could then forestall those rate cuts?

Presumably stronger than anticipated growth, but that presumes that the data between now and October 30/31 is read at face value and not pre-turmoil, and I think that is a big presumption. For example, the case for housing bleeding into the broader economy is based on a significant wealth effect that drives consumer spending into the ground. In contrast, look at the strong showing of the consumer in August, with real personal consumption expenditures up 0.6% for month. Even if consumption is flat in September, the quarterly gain will be 3.2% annualized. 3.2% is nothing to sneeze at.

But, as I said, this is pre-turmoil, so my expectation is that the Fed will discount the figure. Can the same be said for initial unemployment claims? Claims have trended downward since the 50bp rate cut, suggesting that the fears of a broad labor market deterioration that arose after the August read on nonfarm payrolls are overstated. That said, if the concern is the impact of the housing market, then that impact will only be felt in the future, and thus so will the employment impact. Thus, there is a risk that any rebound in September's employment report would be discounted; I suspect that it would take a strong report, over 150k gain, to offset the housing uncertainty.

You get the idea; if the Fed is focused on the housing-consumer-credit market story, the continuing downtrend in housing, and the uncertainty it creates in the forecast, appears sufficient by itself to justify additional rate cuts, especially with inflation sliding.

But is the inflation outlook really all that pretty? Aren't we supposed to be worried about future inflation, not past inflation? And what about those hawkish comments from bank presidents? From Bloomberg:

Poole followed other Fed bank presidents in suggesting that additional interest rate cuts aren't a foregone conclusion. Federal Reserve Bank of Atlanta President Dennis Lockhart said today he had an ''open mind.'' Earlier this week, Philadelphia Fed President Charles Plosser warned that the Fed's Sept. 18 rate cut risks accelerating inflation, and Dallas Fed President Richard Fisher said rates could be lowered or raised as needed.

I so want to pay attention, but my current temptation is to toss out hawkish commentary by bank presidents as essentially out of touch with the Board. This comment on these four is likely right on the money:

''They all have basically zeroed in on the financial market dimension of this rather than the housing spillover dimension,'' said Michael Feroli, a JPMorgan Chase & Co. economist in New York who used to work at the Fed. ''There definitely is a faction, and they are a minority, but they are not trivial.''

Maybe not trivial, but I have already been fooled once on this front, and, in any event, inflation warnings are simply nonsensical after a 50bp cut. Indeed, given the steepening of the yield curve, the fire sale on the Greenback, and the surge in commodity prices, clearly market participants are not giving much weight to such inflation babble.

And if you are worried about future inflation, you likely focus on just those things - oil, gold, Dollar, etc. The Fed, however, looks ready to downplay each and every one of these inflation indicators. On oil, from Fed Governor Frederic Mishkin's March 23 speech:

My view--that recent changes in inflation dynamics result primarily from better-anchored inflation expectations and not from structural change or simply the achievement of a persistent low rate of inflation--implies some very good news: Potentially inflationary shocks, like a sharp rise in energy prices, are less likely to spill over into expected and actual core inflation. Therefore, the Fed does not have to respond as aggressively as would be necessary if inflation expectations were unanchored, as they were during the Great Inflation era.

On exchange rates, from the same speech:

In contrast, unpublished empirical work by the staff at the Federal Reserve Board suggests that, once we take the rising share of imports into account, the influence of import prices on core inflation in the United States has not changed much in the context of reduced-form forecasting models.⁶ At the same time, the influence of exchange rate movements on import prices--the so-called pass-through effect--may have fallen substantially, at least according to some studies.⁷ If so, then the influence of exchange rate fluctuations on domestic inflation may now be less than it once was, when one controls for changes in the volume of our foreign trade.

Both of which imply that at least, Mishkin, and I suspect much of the Board, is significantly less worried about the Dollar, commodity prices, Chinese inflation, etc. than the inflation pessimists.

For my part, I am concerned that the Fed appears to have written off the dollar. My concern stems from rising international tensions - the Fed is dumping additional liquidity into the system at a time when most central banks are attempting to turn off the faucet. The Fed is implicitly, if not explicitly, relying on countries with fixed exchange rates to absorb that additional liquidity at the cost of inflation in those economies. Moreover, those economies with floating rates become the anti-Dollar bets, forcing the Euro area, Canada, the UK, etc, to be the deflationary counterweights to the inflationary US policy.

Is it a surprise that the ECB is under pressure to support the Euro with a rate cut? The only surprise is that there is not more chatter about an ECB intervention if only to erase the idea buying the Euro is a one way bet.

In my darker moments, I fear that the Fed is forcing their foreign counterparts down one of two paths - either central banks with appreciating currencies throw in the towel and match Fed rate cuts, thereby unleashing a fresh wave of global liquidity, or central banks with fixed exchange rate finally decide that they can no longer bear the inflationary cost of supporting the US current account deficit.

Adding to my concerns is that the Fed is overestimating the downside risk to the economy. Certainly, the past correlation between housing downturns and recessions is nothing to ignore. But too many indicators are not consistent with a recession for me to be embrace a dark outlook. Why are initial unemployment claims flat? Why does the consumer appear to have momentum in the 3Q07? Why are readings on manufacturing activity not solidly on the decline? Why did the inventory to sales ratio slide back to its lows? Why does the Baltic Dry Index continue to reach new highs? Why isn't faltering demand undercutting support for oil prices?

Bottom Line: The housing down / inflation down data flow gives the Fed room to continue cutting on the basis of forecast uncertainty. Presumably, strong data would undermine the case for additional cuts, leaving me wary of blow out ISM and employment reports. There is a risk that the Fed did intend the September move to be a "one and done" action, but unless they want to get into the habit of surprising financial markets, they need to make that clear - or the data need to be strong enough to do it for them.

Agree or disagree, Tim would appreciate your comments.

Comments

[dissent]

In my darker moments, I fear that the Fed is forcing their foreign counterparts down one of two paths - either central banks with appreciating currencies throw in the towel and match Fed rate cuts, thereby unleashing a fresh wave of global liquidity, or central banks with fixed exchange rate finally decide that they can no longer bear the inflationary cost of supporting the US current account deficit.

Okay, the first one qualifies as dark moment material: no more 'fresh liquidity waves' please. But the second? Sounds good to me. It has to happen anyway.

We have a Federal Reserve because we have a national economy. The dollar has to decline anyway. The Fed is putting the national economy first and facilitating a dollar decline. And the problem is?

[calmo]

So much here that I like:"..in any event, inflation warnings are simply nonsensical after a 50bp cut."
"...clearly market participants are not giving much weight to such [the Fed minority] inflation babble."

"The Fed, however, looks ready to downplay each and every one of these [oil, gold, Dollar] inflation indicators."

"For my part, I am concerned that the Fed appears to have written off the dollar."

"Moreover, those economies with floating rates become the anti-Dollar bets, forcing the Euro area, Canada, the UK, etc, to be the deflationary counterweights to the inflationary US policy."
I even like this:
There is a risk that the Fed did intend the September move to be a "one and done" action, but unless they want to get into the habit of surprising financial markets, they need to make that clear - or the data need to be strong enough to do it for them. [Isn't the Fed smitten now with this "data dependent" outlook...making that "one and done" obsolete?]
although I can't help smiling about the prospect of cultivating a habit of being surprised or surprising others.
It B a mystery to me now what the Fed expected with the 50bp cut. At the outset I believed it was intended to jolt those long term rates down...to ease the pain for those resets. [You see how easily I can be misled...] And if the mortgage rates did show signs of dropping, they might continue with those cuts. But the mortgage rate rescue is...somewhat hampered...and time is running out. [So imagine them pulling a Fisher and adding 50bp. Exactly. So bring out the ax again --to show that you not only still mean business but that you were earnest to begin with too.]
Ok, wazat a vote for another 50bp from Tim?
I cannot imagine anything less than the 2nd coming that would prevent the Fed from continuing this medicine as the housing led economy falters.

[Robert Edele]

Continued easing (which the Fed is likely to do) is certainly not the correct recipe. As it is inflation is spiraling upwards and kicking the dollar while it's down will hurt, and hurt big time.

With confidence in the dollar dropping and real interest rates falling deep into negative territory as inflation rises, the dollar will feel any abuse very strongly.

That some confidence in the dollar remains is the main factor that separates the USD from Zimbabwe's currency.

Negative real interest rates are not natural and encourage people to buy anything to avoid losing money to inflation. If the money supply is held constant, the interest rates will quickly rise because of a lack of lenders, but in the current system of fixed rates and a floating money supply, the money supply will instead explode causing runaway inflation as interest rates turn even more negative. Central banks can try to hold back the flood with some short term success, but they will eventually drag their own countries down with the USD if they try too hard. China in particular is suffering from rapidly escalating inflation driven in part by buying so many USD.

[dissent]

China in particular is suffering from rapidly escalating inflation driven in part by buying so many USD.

Boohoo, China has to buy dollars in order to maintain their peg and scoop up any American manufacturing job that isn't bolted to the ground.

Boohoo, China has inflation because it has to buy dollars to maintain their peg and scoop up any American manufacturing job that isn't bolted to the ground.

Boohoo, China has a stockmarket bubble because it has inflation because it has to buy dollars to maintain...

BOOHOO AMERICAN COMPANIES WHO PUT ALL THEIR EGGIES IN THE CHINESE BASKET!

[archer]

I may be wrong, but I think the reason that you haven't yet seen the strong signs of a weakening economy is 1) faulty stats and 2) some sectors are running on fumes. Recall that the job creation figures of the last three months were written way down with the last report (although people watching them at the time commented on dubious birth/death adjustments that implausibly showed a lot of growth in construction).

I have a lot of trouble with our employment stats. They don't correspond with the reality I see (and I live in one of the most robust sub-economies, New York City). I know of tons of people who are either "consulting" or "retired" who are actually unemployed but would much rather be working. Participation in the employment questionnaires is lousy and has gotten worse over the years. And our labor participation rate among males 25-45 is worse than in France. But we claim to have much lower unemployment than they do.

Similarly, our GDP figures are tainted by hedonic adjustments.

To see what is really going on in the economy, you probably need to look at hard proxies, like cardboard boxes, electricity usage, etc. That is more trustworthy than the official releases.

[athreya]

The Fed cut by 50 bps in September because it didn't want to do a 25 and then be dragged by the market to do another one. Secondly, having consistently underestimated the housing bust, Fed had to move in to contain further damage from the credit freeze. I think Mishkin's paper at Jackson Hole provides the rationale. On inflation, again going by Mishkin, Fed's soft target is 2% on core PCE, not the 1-2% that hawks (eg: Poole) keep mentioning. So there is no inconsistency in Fed cutting rates now that core PCE is trending just below 2%. Finally, I agree that the claims data has thrown a wrench into the slowdown/recession argument. I keep thinking that the extent of residential construction retrenchment is yet to show up in jobs data. Wonder whether we get another head fake in next 1-2 readings before the bad news starts trickling in. Net net, I expect more cuts, another 50-75 bps in the next 4 meetings.

[Idaho_Spud]

Previous hawkish talk on inflation and moral hazard (most notably by Poole, who somehow managed to make himself look either very uninformed or a hypocrite) was followed by larger than expected 50 basis point FF rate cut.

I go with further easing accompanied by hawkish inflation talk. Note, I do not expect the talk to have any effect on inflation, although the rate cuts certainly will ;)

[phyronic]

Who says the September move was a surprise..
Going into the meeting market implied probabilites were
37% prob of 50 and around 60% prob of 25%?

What wouldn't have been a surprise?

[spencer]

Maybe the most important issue to watch is compensation and unit labor cost. The year over year gain in unit labor cost looks bad, but the last two quarters have been much better.

But if we can keep up the recent quarters of good productivity there is little need for the Fed to worry about
core inflation and another "insurance" rate cut should not be
a problem. But if productivity weakens and unit labor cost surges another rate cut might be too inflationary.

[Daniel]

Archer: "some sectors are running on fumes..."

Contractors often begin tracts without buyers. That's just the development game. When the market dries up they can't just stop building, walk away and wait, they have to finish.
People are still building in some parts of the country. Plumbers and electricians are still getting paid but the finished products are (tracts) standing 'ghost towns.'
It sure looks like "fumes" from here.

[calmo]

From athreya [provoking me like this]The Fed cut by 50 bps in September because it didn't want to do a 25 and then be dragged by the market to do another one.[I like this view. The Fed did not want to be seen as being coerced by the market so instead of the 25bp tap, punched them with 50...putting Tim's "surprise" remark into a very convincing context.] Secondly, having consistently underestimated the housing bust,[I would say "deliberately under-reported"] Fed had to move in to contain further damage from the credit freeze.[but I think "underestimated" works here] I think Mishkin's paper at Jackson Hole provides the rationale. On inflation, again going by Mishkin, Fed's soft target is 2% on core PCE, not the 1-2% that hawks (eg: Poole) keep mentioning.[as per Tim] So there is no inconsistency in Fed cutting rates now that core PCE is trending just below 2%.[no glaring inconsistency...but coherency? persuasiveness?] Finally, I agree that the claims data has thrown a wrench into the slowdown/recession argument. [the erosion of the legitimacy of the labor stats with the "illegal aliens", has no sponsers] I keep thinking that the extent of residential construction retrenchment is yet to show up in jobs data. Wonder whether we get another head fake [and not the Head fake from the Fed?]in next 1-2 readings before the bad news starts trickling in. Net net, I expect more cuts, another 50-75 bps in the next 4 meetings.
A pleasure to read your thoughts here athreya.

[ECONOMISTA NON GRATA]

The question I have to ask myself is...

"When do I redefine the United States of America as a Sub-prime borrower?"

Best regards,

Econolicious

[calmo]

My goodness Economog what a sharp knife you have! So, wazat Gold you're watching? wheat? oil?

When?...when the foreign held tbills breached $1T?
...when the Financial GDP breached 10% GDP?.
..when it became obvious that the administration was "stated intelligence" like "stated income"?

I give up.

[anon]

" For my part, I am concerned that the Fed appears to have written off the dollar. My concern stems from rising international tensions - the Fed is dumping additional liquidity into the system at a time when most central banks are attempting to turn off the faucet. The Fed is implicitly, if not explicitly, relying on countries with fixed exchange rates to absorb that additional liquidity at the cost of inflation in those economies. Moreover, those economies with floating rates become the anti-Dollar bets, forcing the Euro area, Canada, the UK, etc, to be the deflationary counterweights to the inflationary US policy."

This fellow is the leading fed watcher in the blogosphere? Yet he doesn't understand that a Fed rate cut doesn't "dump liquidity" into the system. That's only been true with the extraordinary discount window actions, but has nothing to do with normal or abnormal funds policy. Surprising how many of these experts don't understand how the Fed balance sheet works in practice.

[calmo]

anony types [and I type back like this]This fellow is the leading fed watcher in the blogosphere? [Well Tim would be the last one to proclaim this, but, yes absolutely: the leading edge of the leading watchers...in advance of radar even...saucer like eyes and a satelite dish-like head to process the data.]Yet he doesn't understand that a Fed rate cut doesn't "dump liquidity" into the system. [And *you*, possible expert and fellow, understand that the 50bp decline, "the loosening" really means (something totally different from "the liquidity dump")?...we await your expertise] That's only been true with the extraordinary discount window actions,[the paltry $2B loans to those 4 banks, yes?...which I don't think Tim was talking about.] but has nothing to do with normal or abnormal funds policy.[Agreed, I think. We are talking about the prime interest rate move from 5.25% -> 4.75% making it cheaper to borrow, lowering the cost of financing, adding liquidity to ease those frozen markets, ie that liquidity dump. ] Surprising how many of these experts don't understand how the Fed balance sheet works in practice.[I'm sure Tim who worked for one of the reserve banks for a few years would love to hear your view of it.]

[anon]

calmo:

Normal excess reserve levels are miniscule relative to system balance sheets - at any funds rate. Even the excess reserves recently injected in conjunction with the first discount rate change, while large in comparison with normal levels, were small relative to system balance sheets (trillions). In either event, the focus is excess reserves, to which funds market flows are very highly leveraged - hence the relatively small levels of funds actually required to achieve the desired rate effect. The purpose of the first discount rate cut was to get the funds rate back in line, erring below the target rate rather than above it – making flow of funds (i.e. liquidity) pricing in synch with the intended operational rate zone. The purpose of the funds rate cut was to lower the target rate following this extraordinary window intervention.

This is so-called 'high powered' (i.e. super leveraged) money - not the money that reaches overseas. That will be a function of the general rate effect, not some massive 'liquidity dump' by the fed. Lowering the funds rate is not a 'liquidity dump' in any fashion other than for dramatic description - certainly not in substance. I'd like to see him disagree with what I've just written and know why. You seem to agree more than disagree despite your indignation.

[calmo]

Thanks for the reply anony, but you may be somewhat underwhelmed by my reserve banking knowledge which an ordinary oaf might duplicate in 5 min by resorting to Wikipedia. (calmo's bully has no equal.)[anony makes it 2 minutes.] (You see how ruthless it is.)
Still, my indignation is that you have thrown stones at Tim rather than engage him...like this:
Are you referring to the various measures of money supply here? Normal excess reserve levels are miniscule relative to system balance sheets - at any funds rate.I'm nodding along [with some italics like this] until I get to the dark forest here [where the *stars* indicate some of my stupification]:The purpose of the first discount rate cut was to get the funds rate *back in line*,[large borrowers wanted $ that large lenders were unwilling to lend at current rates because the risk was under-priced...so the Fed lowered the bar in making funds cheaper...in effect assumed the risk lenders were not prepared to take?] erring below the target rate rather than above it [as if it could have gone the other way? I don't understand this view.]– making flow of funds (i.e. liquidity) pricing in synch with *the intended operational rate zone*. The purpose of the funds rate cut was to lower the target rate following this extraordinary window intervention.

Ok, I do need to visit wikipedia to learn these terms. I shall return anony.

[Lafayette]

calmo: I cannot imagine anything less than the 2nd coming that would prevent the Fed from continuing this medicine as the housing led economy falters.

Quite right. All the rest is senseless palaver from those who miss an excellent opportunity to say nothing.

What else can the Fed do? Raise taxes? No. Fix prices? No. Raise/lower federal expenditures? No.

Besides, should we really, really be convinced that because an economy has finished a bubble that its is moribund? Economies, I suggest, are far more robust than we imagine.

Too many people have been watching Hollywood movies where some natural catastrophe is about to end the world as we know it. And, they think equity markets contain the same magnitude of menace. Another example of Naive Nonsense.

[anon]

Calmo

Point taken on stones - not my usual style. I thought it necessary in this case.

People are responsible and accountable for what they write. This type of "analysis" plays to the masses for effect. You say he worked at a bank. Ironic. You'd never get an actual Fed communication talking so cavalierly about "liquidity". The reason, not necessarily political, is to reflect accuracy and precision where important. There are many cases of people who worked at central banks who have little idea how a CB balance sheet actually works. I don't know the gentleman’s exact experience, but I know I don’t like the description.

2 minutes? You'd be surprised how long, what, and where.

system balance sheets - I mean the banking system, with various forms of money

*back in line* - with the 'credit crunch', fed funds started to trade above the target rate of 5.25 % - mostly because banks started to hoard reserves - i.e. the velocity of that money slowed - so the Fed added funds and used easier discount rate policy to help out, to get the funds rate back to the target rate

*the intended operational rate zone* - having gotten the funds rate back to the target level, the fed actually erred on the side of additional easing to ensure that funds did not trade above the target rate of 5.25 % - i.e. they erred on the side of ease, creating a wider 'zone' of daily funds rates than is normally the case - it got down to around 1 % at the extreme - this cushion or zone was also necessary because it was difficult to predict the hoarding propensity of banks on a daily basis and therefore difficult to predict the actual funds rate that would result from a particular reserve setting – these conditions while the target funds rate was still 5.25 % naturally paved the way for an official decrease in the target rate, which became the case.

says...

calmo says...
"My goodness Economog what a sharp knife you have! So, wazat Gold you're watching? wheat? oil?

When?...when the foreign held tbills breached $1T?
...when the Financial GDP breached 10% GDP?.
..when it became obvious that the administration was "stated intelligence" like "stated income"?"

The day that George Bush started use Roberrt Mugabe as a role model. ;-)

Econolicious

[calmo]

You are starting to emerge from the fog surrounding me anony. Let me persist that Dr Tim Duy is no ordinary "guy that worked in a bank"People are responsible and accountable for what they write. This type of "analysis" plays to the masses for effect. You say he worked at a bank. Ironic. and for us recreational economists (a growing club and you could join and strike up a tag, you could anony) a valuable resource who has a lengthy record of informative posts here (usually coinciding with Fed releases). Even if it turned out Tim did not have a PhD in Economics doing research for one of the Reserve Banks, I would still read him ... and learn.
So what part of your post was "accountable and responsible"... and the other type of "analysis" which we recreationalists (I speak personally of course) need to recognize? ["Ironic."...do you see your own post also suffering with this charge? ...ie, don't mind my brief foray while I slap someone's ass (and not his position/argument) for not being cognizant of his environment, an environment he carefully constructed.]
We could be more accommodating and tolerant...asking for clarification first, throwing the spears later...if ever.
Ok, that was my last spear, you?
Alrighty then.
Have I told you recently what a pipsqueak I am on Reserve Banking? (seriously, this could be a cover for quite a bit larger chunk of my Economics ignorance.) [It B true.]
So, in the interests of burning some of that fog off around me, I require more narrative on how this credit crisis (major parties refusing to deal) [large players desperately needing $ that other large players were not forking over] spurred the Fed to use (enforce?) the discount window and secondly drop the prime rate 50bp and why this talk "liquidity dump" is so inappropriate (no one expects the Fed to use this language, but for pipsqueaks like me, this has real force). I am so impressionable...and good thing too, now that we have your experience to tap and get further views on what is happening with the Investment Banks.

[anon]

Calmo -

Fair enough. No more spears (within reason).

The point again was around this description:

“ … the Fed is dumping additional liquidity into the system at a time when most central banks are attempting to turn off the faucet. The Fed is implicitly, if not explicitly, relying on countries with fixed exchange rates to absorb that additional liquidity at the cost of inflation in those economies …“

It’s a minor point I suppose. Except that words mean something. And the word in this case is “liquidity”. The Fed targets the short-term rate – the fed funds rate. The discount window for banks and repo facilities for dealers are simply tools for the Fed to achieve an end – an actual Fed funds rate that tends toward the target Fed funds rate. When the Fed needs to “prime the pump” or reverse it, it does so in order to achieve a steady flow of funds anchored around some stability in the fed funds rate. That’s really all there is to it. As I said, the amounts involved are fairly small. This is because the Fed enjoys the leverage of having a commercial banking system that must respond with great discipline to the authority of reserve requirements. The reserve requirements in money terms are relatively small. It’s the discipline of banks adhering to them that is important to monetary policy and interest rates at the margin. The penalty for failure is monetary and reputational punishment. So the Fed normally (and in this case abnormally) doesn’t need to inject massive amounts of “liquidity” for the banks to meet their reserve requirements. And it certainly isn’t the source of any great amount of liquidity that can be recycled overseas. That is simply an incorrect view of the way the banking system and broader financial system work. Given the importance of the larger topic of international funds flows, it is not helpful to describe it in such a blunt and inaccurate fashion.

You’ve responded quite fairly and appropriately to my inappropriately impolite intrusion. Thank you for having the patience to do so.

[Lafayette]

anon: The Fed is implicitly, if not explicitly, relying on countries with fixed exchange rates to absorb that additional liquidity at the cost of inflation in those economies …

What "fixed exchange rates"? We've been off the Gold standard for quite some time.

European currencies became convertible in the late 1950s, before which there wasn't much to convert into from dollars. That has changed considerably. The dollar has decreased drastically against the Euro and the Euro appreciated accordingly, without suffering all that much damage in the transformation.

Liquidity is not the point, I suggest. It was augmented as a palliative measure, to allow banks to borrow from another source -- in addition to inter-bank lending at overnight rates, which had gone dry in fear.

the sub-prime putrefaction is still very much there, and banks over the next few years are going to have some real bottom line damage cleansing it out of their system.

Which is fitting justice, one might think, for their idiocy in having bought such instruments in the first place.

[anon]

Lafayette -

Those were Tim Duy's words I was quoting, not mine. He's probably referring to China, much of the rest of Asia ex-Japan, and the Gulf.

And I agree with you that liquidity is not the point. That was my point as well.

bwt, I think the global distribution of US originated credit risk is being underestimated as an effective diffusion of losses away from the US in this particular credit cycle.

[Lafayette]

anon: He's probably referring to China, much of the rest of Asia ex-Japan, and the Gulf.

Ah, yes, the dangers of citing out of context. Sorry.

But, in that case, exporting a bit of inflation to China would do wonders for America's balance of trade.

I still cannot make sense of this polemic. Never mind.

[Lafayette]

anon: I think the global distribution of US originated credit risk is being underestimated as an effective diffusion of losses away from the US in this particular credit cycle.

Fool me once, shame on you. Fool me twice, shame on me.

This is the second time in seven years that a speculative frenzy originating in the US has had a tsunami effect on capital markets beyond its shores. Which makes two times too many.

Buy my bogus over-valued stocks. Buy my bogus subprime packaged "assets". And, whilst your at it, buy my T-notes to finance a chronic current account deficit.

It's getting to be all a bit too much. (Especially when Uncle Sam springs a unilateral war in the oil rich Middle East. That's the cherry on top, is it?)

[DEXTER]

Toe the line