I am the first to say that I do not understand the whims of the market, but today we saw a pretty schizophrenic display. Attention in the US focused on the Fed’s Open Market Committee statement. Earlier this week, not much was expected, since the Fed is somewhat constrained by fact that the Obama team has not come forth with plan for the banking industry. But then rumors started circulating that the Fed would commit to buying long-dated Treasuries to lower interest rates (30 year bond rates had risen nearly a percent from their lows last month, and of more immediate concern to the Fed, fixed mortgages rates, which had blipped down, had risen as well).
The 30 year bond rose prior to the announcement, as did gold (not necessarily contradictory, if you are buying gold out of a worry about the long-term health of fiat currencies). Similarly, stocks gapped up at open, since if the Fed engineers lower rates, that would help housing, banks, and make equities look more attractive relative to bonds.
The key section of the Fed statement was weaker than what was hoped for.
The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. The focus of the Committee’s policy is to support the functioning of financial markets and stimulate the economy through open market operations and other measures that are likely to keep the size of the Federal Reserve’s balance sheet at a high level. The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant. The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.
So the Fed reaffirmed its commitment to buying mortgage paper in size, and said it would buy Treasuries IF it would help “private markets”. That is as clear as mud.
Now there has been an assumption among most observers that the reason that the Fed is contemplating buying Treasuries is to drive rates down. Bernanke has discussed this idea in papers and presentations on deflation before he became the Fed chair. However, as Fedwatcher Tim Duy points out, it might be worth reading what the Fed actually said, since these statements are crafted carefully:
Conventional wisdom has that any Fed action to purchase longer-term Treasuries would be done with the intent of holding interest rates low, thereby stimulating economic activity. That, however, is not the implication of this sentence. Instead, the Fed views Treasury purchases only as a mechanism to support effective functioning of credit markets, which suggest that the Fed is not worried about controlling the level of longer term interest rates, but the spread between Treasuries and other assets.This also suggests that the Fed is not particularly interested in expanding the balance sheet further via Treasury purchases. They may be willing to, but I am not sure how Treasury purchases will improve market functioning. To date, improving credit market efficiency has meant purchasing or holding as collateral risky assets, or even safe assets that the market currently shuns, not riskless Treasuries. What factors would cause a reversal of that position?
Moreover, one should also question the willingness of the Fed to fight against rising interest rates if those rising rates were the result of a shift to riskier assets and credit spreads fell to more normal levels. Presumably, this would correspond to a loosening of credit conditions, which in and of itself would be stimulative even if rates edged upward.
This distinction, and the Fed’s apparent reluctance to balloon its balance sheet unduly is telling. Some commentators (most notably John Hempton) have argued that Bernanke NEEDS to have the appearance of being reckless, that the debt deflation vortex is so powerful that he needs to do something to jolt consumers who are not at the end of their rope to spend more. Thus, while helicopter drops of cash may be out, letting the Fed balance sheet grow in the next year to, say $5 to $7 trillion would certainly focus the mind.
However, this may all be moot. If mortgage rates continue to rise despite the Fed’s efforts to contain them by lowering spreads, then the Fed will presumably buy Treasuries. But it is odd that the statement (in effect) renounced the approach that Bernanke advocated in his academic work, of driving down long Treasury interest rates to combat deflation.
Maybe bond market investors are better readers, or are simply more skeptical. 30 year Treasuries promptly retreated, as did gold, while stocks faded a wee bit from pre-announcement levels and averages continued upwards to the close. Financials in particular showed big gains. Technicians would stress that the market broke through an important resistance level, and if you are of that school of thinking, you would expect some follow through.
The FOMC annoucement overshadoved (at least in the US) other economic news. An EIA report showing a bigger than expected increase in inventories was shrugged. off. And perhaps more telling, the outlook is becoming sufficiently grim that international economic agencies are slashing their forecasts (mind you, they are about as likely as the sell side to tell you that things will be bad).
Last night, we reported that the International Institute of Finance was calling for a global GDP contraction for 2009. The IMF today, while not going as far as the IIF, got about as downbeat as one could expect them to be, predicting a marked contraction in advanced economies. From the Financial Times:
[T]he International Monetary Fund increased its estimate of credit losses on US-based assets from $1,400bn to $2,200bn. It also said world output, measured at market exchange rates, would fall in 2009 for the first time since the second world war. Weighted by purchasing power, growth would be very slightly positive.The new growth forecasts mark a huge revision – down by more than 1.5 percentage points – from the IMF’s previous forecast for the year in spite of the inclusion of the fiscal stimulus efforts by governments into its predictions for the first time. Advanced economies, the IMF predicted, would contract 2 per cent in 2009 with the UK hit hardest.
In Geneva, the International Labour Organization said the global recession would lead to a “dramatic increase” in unemployment this year, which would certainly lead to 18m-30m additional unemployed and more than 50m “if the situation continues to deteriorate”.
doc holiday 
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Let’s call this Phase II.
Phase I is the popping of the bubble and resulting crash of the financial system, which results in contraction of the real economy.
Phase II is the contraction of the real economy begins to further impact the foundations of financial markets, that is below the bubble.
How low does that go? Well place your bets, but one thing for sure, if the TARP was an failed answer to Phase I, what passed in the House today can be considered the fiscal equivalent of the TARP to Phase II, and we should expect about the same results.
And the optimists out there can be reminded, we still haven’t come close to addressing the problems of Phase I.