Fed Watch: More Easing Expected

Today, the Fed lowered the target interest rate to 1%. Will the Fed lower the target rate even further if things don't improve?:

More Easing Expected, by Tim Duy: The FOMC performed as expected today, delivering a 50bp cut that returns rates to their lows of the Greenspan era. More importantly, Bernanke & Co. made clear that further policy easing remains on the table.

The FOMC statement describes an economy in recession without actually using the “R” word:

The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

Any other assessment would have been surprising; by all measures, economic activity fell off a cliff as we entered the second half of this year. Today’s durable goods report is no exception, with nondefense, nonair capital goods declining 1.4% in September, extending a 2.2% decline the previous month. The intensification of the credit crunch (yes, Virginia, it is a crunch), increased hesitation to expand capital outlays in the current environment, and slowing global growth suggest that investment activity will show even greater declines in the months ahead.

Consistent with the darkening outlook, the incoming flow of data is likely to be horrid, especially during the next two quarters. In particular, the employment report will soon reveal the big declines in nonfarm payrolls consistent with a recession. An increased pace of job losses will sap aggregate household budgets of the real gains afforded by falling energy prices. Consequently, spending data will remain weak. Overall, the data will argue for additional policy response, and the Fed’s statement makes clear that they are prepared to ease policy further as required.

But will that easing come in the form of lower rates? And how far would the Fed go?

Brad DeLong reminds us that the Taylor Rule places the policy rate at zero, but there is some concern that rates lower than 1% will interfere with the normal operations of money market funds – they need to remain profitable if the Fed expects them to continue to function. Also note that only four district banks requested a decrease in the discount rate, which some believe indicates the rate cut cycle is near its end, or that there was less support than the unanimous vote would seem to indicate. If so, expect some hawkish talk from district presidents.

Still, unless the Fed believes that technical reasons prevent moving much below 1%, I doubt anything short of a dramatic improvement in financial markets would eliminate the possibility of another rate cut. Even under such conditions, the pressure to ease further will be immense as labor markets deteriorate (this has always been a risk of the Fed’s aggressive push). But suppose that conditions warrant a prolonged period of constant rates. In the current environment, even holding rates at 1% is not the same as the end of the easing cycle. Indeed, the effectiveness of rate cuts at this point is questionable. The reaction of market participants to the coordinated 50bp cut earlier this month was not exactly a vote of confidence in the efficacy of this particular policy tool. Given the ongoing problem in financial markets, are any of us under an illusion that the price of money is the dominant policy challenge? How many believe that the final 100bp will have a measurable impact on economic activity? This is especially true with regard to the near term; if the last 100bp has much effectiveness left, the impact will not be felt until late next year. That is not meant to say that we should reverse course and start raising rates. Only that future policy easing will be more about the extension of tools that increase the Fed’s balance sheet rather than on the level of rates in the overnight markets.

Of course, expanding the balance sheet, effectively replacing liquidity that is drying up in various parts of the financial markets (by, for example, purchasing commercial paper), should not be seen as a panacea to the current turmoil. I view it, along with Treasury’s capital injections, as more of an effort to prevent the turmoil from leading to an outright collapse in the banking system rather than something that will increase lending. Policymakers would be happy to see lending activity expand. But deleveraging threatens to dry up credit at a pace faster than the Fed and Treasury can compensate. Moreover, a portion of the credit crunch is attributable to a reversion to traditional underwriting standards; policy will be unlikely to reverse this trend (nor should it). And, with economic conditions deteriorating, and unemployment expected to rise, banks will increase their loan loss provisions, further weighing on lending activity. In short, at best Fed and Treasury can limit the extent of the crunch, and hopefully prevent significant overshooting.

With the reversal of commodity prices since the summer, policymakers no longer worry about inflation. This provides room for additional easing, although some think it is shortsighted:

With today’s cut the Fed is throwing gasoline on an inflationary fire that it created but continues to ignore. The Fed has mistaken temporary drops in commodity prices, which merely resulted from de-leveraging, for clear evidence that the inflation menace has been quelled. However, once highly leveraged players have been flushed out, commodity prices will resume their ascent, pushed skyward by the most inflationary monetary policy in history. –Peter Schiff, Euro Pacific Capital

The argument is that underlying conditions place the Dollar’s newfound gains at risk of another reversal. Once the deleveraging is complete, foreign investors will realize they are now awash in Dollar denominated assets at a time when the US Treasury is expected to unleash an unprecedented quantity of such assets on global financial markets. The Dollar and commodities will reverse direction accordingly. I admit to being sympathetic to this story, but would note that sufficient slack looks to be opening up in the global economy to absorb these assets (especially if China continues to backstop the US economy). I assume this is the Fed’s view as well. If the Fed is in error, the yield curve should steepen dramatically in coming months. Bernanke & Co. would then be forced to reassess their policy choices.

Bottom Line: The combination of the Fed’s statement and the likely path of data suggest another 25bp of easing in December. The global slowdown, dollar strength, and commodity reversal all leave inflation off the table as a concern. Only technical considerations or a dramatic improvement in financial markets would prevent the Fed from further cuts, but with the ability to pay interest on deposits, a zero interest rate is not an impediment to expanding the Fed’s balance sheet. Indeed, this is almost certainly the policy focus at this point. Inflation hawks might be unsettled by continued rate cuts, but hawks have had little impact on policy outcomes in this cycle. Consequently, the safe bet has always been for additional easing – even when only 100bp remain.

Comments

[mike]

The most aggressive plan yet to address the housing recession and its impacts. Would it work?

http://www.marketwarnings.com/2008/10/massive-mortgage-aid-planned-in-us-will.html

[fusion]

The spread between 5-year TIPS and nominal treasuries is predicting about 30bps of deflation per year over the next 5 years (http://www.bloomberg.com/markets/rates/). Either TIPS have been pushed low for technical reasons (e.g., hedge funds selling for liquidity) or the market is not really concerned about inflation.

[Ever More]

"Moreover, a portion of the credit crunch is attributable to a reversion to traditional underwriting standards; policy will be unlikely to reverse this trend (nor should it)."

Ramp up high credit rating borrowing sufficiently to replace the lost low credit rating borrowing (plus growth in total credit on top of it). With domestic consumption already higher than domestic output, constant expansion from this point requires increasing domestic consumption ever higher than domestic output.

A mistake was made in the calculations, allowing borrowing to push domestic consumption beyond domestic output. Instead of correcting the mistake (balancing domestic demand near output), policy is attempting to grow credit enough to keep demand growing far in excess of output. Foreigners will no longer make many loans to private citizens, so public borrowing is attempting to borrow enough more to compensate for the lack of private loans. The flight to safety is permitting this extra borrowing to go on, for now.

Ever more credit growth, even if a mistake allowed too much credit growth in an earlier period.

[hari]

There is an end to monetary policy - as Fed gets closer to zero rate. Japan mellowed for a decade or so below (effective) zero rate before catching the growth cycle. If BB doesn't watch it carfully, he's presently destined to repeat Japanse experience, me thinks.

Having allowed the exuberance to persist with Feds rates and wahtnots - it must now take the economic consequence and allow the bottom to surface or delay it indefintely (may be).

[Inflation is the Enemy]

The CPI continues to go up, while GDP shrinks. Inflation is not protecting us, it is reducing the ordinary consumers' standard of living. Inflation is the enemy. Let prices fall, and ordinary consumers will be able to buy more. Then policy won't have to drive debt levels ever higher to compensate for falling consumer purchases caused by higher prices. Falling prices due to productivity gains will increase quantity sold naturally.

Find some other way to smooth out cycles. Inflation does more harm than good.

[reason]

"The records stuck, the records stuck, the records stuck ..."
Monty Python.

[Winslow R.]

Where does the anti-inflationary bias come from?

I've come to believe an anti-inflationary bias comes from having a trust-fund (heavily invested in tsy secs) mentality. The mentality comes from either having a trust-fund or an income stream from someone that does or even worse, hopes for a job prospect from those that do.

Brad Delong, professes an anti-inflationary bias as he still hopes for a political post.

Stiglitz and now Krugman have now been fully compensated and now no longer seem to have the same 'hang-ups' as so many economists.

[Barkley Rosserr]

Might this not be the time to use some of those other tools the Fed has in the old traditional textbook list, such as lowering required reserve ratios?

[flow5]

If the FED's "tax rebate" doesn't fall to zero (acts like the lower FFR bracket), but securities remain illiquid, & creditworthy borrowers remain scarce, then a liquidity trap will result in "pushing on a string".

[kthomas]

Winslow, swinging the heavy bat!

I am apt to agree. Hell, wish I had one of those trust funds, too!!!

[kthomas]

I kept hearing the term "Flight to Quality".

Seems there's nothing of any quality out there to invest in, besides good ole human capital.

[calmo]

Barkley, wouldn't you say that the TAF and other supplemental (TOFFEE) measures make tinkering with the reserve ratios a tad staid?
Winslow, I have come to expect more from you than this crass cynicism. I am counting on you to discontinue the mud-slinging and join the effort...no matter how tempting it is to join the mess.
Thank you as usual Tim. I can only add that the marketing of the Fed now seems more important than the actual decision(s). Will the new administration continue this marketing by ousting Bernanke?

says...

"lowering required reserve ratios?"

Paying interest on excess reserves, is currently restrictive. It lowers the system's expansion coefficient. Now the FED needs idle excess reserves to offset their liqudity influsions.

It would make more sense to expand the federal budget deficit and then use the proceeds to finance real investment by raising reserve ratios. Money creating depository institutions aren't financial intermediaries unless they have a 100% reserve ratio applied to all of their deposit liabilities.

[flow5]

http://research.stlouisfed.org/fred2/series/TOTBKCR?cid=101

This shows bank credit for commercial banks. Whereas financial intermediaries, or the non-banks are concerned, they are experiencing "deleveraging" or what I would call disintermediation (an economists word for going broke). But the commercial banks suffer no disintermediation as a system because lending by CBs is not predicated on savings. It is predicated on monetary policy.

The viscous economist's mentality doesn't understand:

A. the difference between the supply of money and the supply of loan funds.
B. the difference between means-of-payment money and liquid assets.
C. the difference between financial intermediaries and money creating institutions.
D. didn't recognize aggregate monetary demand is measured by the monetary flows (MVt) not nominal GDP.
E. don’t recognize that interest rates are the price of loan-funds, not the price of money
F. don't recognize that the price of money is represented by the price (CPI) level.
G. don't realize that inflation is the most important factor determining interest rates, operating as it does through both the demand for and the supply of loan-funds.

If economists understood the real world commercial banks would be prohibited from paying interest on their deposits because you can't take money out of the banking system & why should they pay for (as a system) for something they already have?

[wudu]

"why should they pay for (as a system) for something they already have?"

Indeed.

[anon]

Required reserve ratios are completely irrelevant.

Required reserves are currently negligible.

Actual reserves are currently excessive but compensated.

Actual excess reserves are merely an alternative source of funding.

Banks lend from capital, not from reserves.

[anon]

So now cuts are "on the table" after being "off the table" a few months ago.

[Winslow R.]

Sorry for being so cynical in my past post.

Tim wrote:

"Brad DeLong reminds us that the Taylor Rule places the policy rate at zero, but there is some concern that rates lower than 1% will interfere with the normal operations of money market funds ................

.......How many believe that the final 100bp will have a measurable impact on economic activity?"

Disregarding the lack of impact from the first 425 bp of drop, this is as close to an admission (from a non-postkeynsian) that the monetary policy transmission tool is broken. Tim should be commended.

Though not as nice as a plaque and/or donation......

Good job, Tim :)

[Michael Cohen]

Some numbers here are important. Seekingalpha.com has a graph of total private and public debt. Total credit in the US economy is 3.6 time the GDP. This is roughly twice what it was under Bill Clinton. The peak of Clinton years was rougly 1.8 a little among the maximal peak during the great depression. This is a difference from 1.8 times the GDP. The current debt level is unsustainable. With the redistribution of income upwards taking place since Reagan and the US Gini coefficient .49 neck and Neck with the Ivory coast and far out of the range of the Western World, this is bound to happen. This number scales from zero to 1 and the World Maximum is .7. It .1967 it was .38 high but in the European range, Sweden now is .26 for example. Public Debt us .6 GDP not good but

In the current climate this was inevitable. As the economy contracts more will default on their debt. As more of the public fails to pay the rich investors who had too much capital accumulated and too little ability to invest will themselves find their assets devalued and default on the levered debt. As Marriner Eccles mentioned in his memoires if the public lacks the wealth to buy the Goods and services produced by the economy then a deflationary spiral eventually becomes inevitable. More lending by large institutions to the consumer will simply at best postpone the problem.

So what can we do to avert a Depressionary Spiral? The plan should be to replace Debt by Equity. The real good news is this is deflationary, a hyperinflation which could equally well happen is a danger which is much more difficult to deal with. In a deflationary environment the government which has leeway. On the Monetary side the interest rate card has already been played. In any event cheap and plentiful credit will do no good if there is nobody at the base of the chain to buy it. This is what happened in the 1930s and will likely happen now.

There is very good news here because with understanding their is much the state can do. First off It can enforce this massive revaluation in the market. Let the creditors loose their shirts as much as possible without having the Chinese sell off us Debt and turn the United States into Argentina.

Second it can buy up much of the excessive debt at the base of the food chain, i.e. Credit Card Debt, mortgages ... etc. With debt in hand the repayments can be adjusted down 50% and relatively generous terms can be enforced by forcing heavy penalties on the assumption of new debt by people who cannot afford it.

Third, as the market has done a damn poor job recently in investing in useful goods and services. The state has given us the internet, air plane technology, drugs, advances in ultrasound, the microprocessor, and other things through direct research, investmaent in labs and other thngs. Its time we let them make large investments and spin them off to alternative energy.

Fifth at this point even Martin Feldstein, Reagan's chairman of the council recommends a large investment in infractructure. Its about time we do this. If we want an advanced American economy its what is necessary.

[Winslow R.]

"Total credit in the US economy is 3.6 time the GDP. This is roughly twice what it was under Bill Clinton."

Stability depends on the ratio of Total Credit/Gov debt or the 'leverage ratio'.

"The plan should be to replace Debt by Equity. "

Agreed

"Second it can buy up much of the excessive debt at the base of the food chain, i.e. Credit Card Debt, mortgages ... etc."

Agreed which will reduce the leverage ratio (Total debt/gov debt)

You advocate a Strong Treasury which will lead to stability, not necessarily a good thing unless you see Japan as nirvana.

What can the Fed do so that we can have a Strong Fed and Strong Treasury and therefore a Strong Economy?