A low volume, high quality source from the demand side perspective.The podcast is produced weekly. A transcript is posted on the day of.

Monday, January 14, 2008

What is the Fed’s cutting of rates supposed to do? -- podcast transcript

The fervor and fever of the current economic debate is all about whether the Fed will cut rates or by how much or if it is going to be too little, too late? The Fed’s decisions are gamed, er, priced in the options and futures markets.
  • Are we in a recession?
  • Are we going into a recession?
  • Will the Fed cut interest rates in time to keep us out of a recession?
  • Has the Fed done the right thing so far, or have they been quote too concerned unquote about inflation?
  • Will the federal government produce a stimulus package to keep us out of recession?
A little critical thinking.... Remember.

Interest rate cuts by the Fed have a lag of 12 to 18 months before they get into the general economy. Today we are under the influence of the high rates at the end of 2006.

Oil prices are moving in the opposite direction and have a similar lag and similar macroeconomic effect.

Whether the Fed cuts tomorrow or at the end of the month is critical for the market, because the market is not rational. It is critical for “confidence.” It reminds one of the cowed Fed during the absurd explosion of stock prices in 1927, ‘28 and 29. The market is telling the Fed to say what the market wants to hear.

More critical thinking.

What do we expect lower rates to do?

Greenspan had to lower rates to one percent in order to create a housing bubble. If we are trying to recreate that, we should think again. We got three years of tepid growth at the cost of trillions in both public and private debt. Now we have a financial sector in dysfunction and acres of houses abandoned. Those in their houses have the sickening experience of watching their retirement nest egg deflating as they approach the need for it.

Speculators, er, investors could use lower rates to make leveraged plays pay off. Leverage is a key component of all bubbles. But you need rising asset prices. An asset bubble in commodities is already forming. Oil is trading at 50 percent above fundamentals. Grain and other futures are getting pumped up. Gold is tickling $900 to the ounce. But speculation in commodities is very destabilizing. Inflation on the front end and big risks at the back end for people who set up to produce commodities only to have the bottom drop out of prices when they come to market.

Do we expect business investment to take off with lower rates?

Significant business investment in the last so-called recovery was absent. It is a mistake to think that businesses invest because money is cheap or tax incentives are available. They invest when they see opportunity for profit. Once a project is decided upon, they may make forays to government offices to seek tax concessions or cheap money, but without the prospect of profit, no form of easy financing will promote business investment. A sagging economy is not a happy place for those looking for potential profit.

Reflect on the cash on the books and the corporations instituting buy-backs, and ask, “Why are they not investing?”

But back to the question.

What do we expect interest rate cuts to do?

We don’t want a commodities bubble. We might inflate stocks for awhile, and that would be good, but it is not the real economy. We are just not going to reflate the housing bubble.

What we want is investment. We nwant to temper the downturn and create some sort of investment. Neither housing nor business investment is a huge part of the economy by itself, but they are the catalysts of growth. Another target could be public infrastructure. Bonds for sewers, water mains, roads, and so on.

Simple borrowing and spending that does not generate investment is simply borrowing and spending.

What do we expect Fed rate cuts to do? Twelve to eighteen months down the road?

Many, the Fed chairman himself included, suggested rate cuts somehow addressed the financial sector collapse. But this is a solvency problem, not a liquidity problem. They may come together if one of these banks goes belly up while holding capital from the special auctions, I suppose.

Here is what Fed action will do. And this is the reason for the fever around it.

The financial sector ran its unregulated games behind closed doors and they came up craps. Mortgaged-backed securities, leveraged instruments in themselves, were used to leverage more. Now it is all unwinding. The game is still behind closed doors, but every once in awhile somebody goes in with a big bag and comes out with an empty one.

By moving the public eye to the Fed, it creates the illusion that whatever happens to the economy will be because the Fed did or did not do something with interest rates. If the economy tanks, Bernanke will be on the cover of Time. If the economy recovers — how could it? — Bernanke will be on the cover of Time. If the economy muddles along — Bernanke will be on the cover of Time.

But it is too late to demystify mortgages for millions of subprime borrowers or vet preposterous innovative securities before they get eaten by the ferocious demand of .... investors looking for fifty beeps more return.

But what is the interest rate supposed to do?


Congress and the president are getting together, it sounds like, on a stimulus plan. And we have to ask, yes

What is stimulus supposed to do?

The Timely, Targeted and Temporary mantra is a quaint formulation of the hypothetical best, but it is being pushed into an arena that is teeming with large and growing deficits already in progress. Yes, deficit spending is already in the hundreds of billions of dollars per year. We’re talking about more hundreds of billions, not moving the hundreds of billions from the tax cuts for the rich to legitimate stimulus targets.

It is true, if we are going to borrow to spend, we need to make certain it is potent spending. Tax cuts for the very lowest and spending increases on unemployment compensation or food stamp increases.

Otherwise it needs to be triage for state and local governments. States and municipalities are getting hammered by the housing bust, both in increased costs and in reduced property tax revenues. There is no sense in giving tax cuts to people so they can buy more Chinese lawn mowers or Japanese cars when we could be buying American teachers and policemen. These people will be happy to spend their paychecks, and maybe if we make them, they’ll buy a Chinese lawn mower.

To be completely clear.

The federal government, principally the Fed, screwed up by not policing the mortgage markets nor vetting the silly CDOs and SIVs. Now the locals are suffering. The best stimulus would be federal support to fill in for falling tax revenue and, further, to keep road, sewer, water and other local projects from being shelved.

Timely, temporary, and very well targeted.