Arguing Against a Rate Cut

Despite the widely-held view that the Fed will lower the Federal funds rate another 25 basis points this Halloween, some continue to argue against further reductions.

We’ve taken that position here before, and will recap some of the reasons. The 50 basis point cut in September was a pre-emptive strike, based not on evidence of slowing growth but out of concern for the deteriorating housing market and fragile conditions in the money market.

While the Fed’s action gave a nice boost to the stock market, and reduced Libor spreads and credit default swap prices somewhat, it also led to a rise in long-term rates based on increased inflation expectations, and higher long rates are a negative for house prices. And it appeared to do almost nothing for the continuing crisis in the money markets. Commercial paper outstandings continued to fall after the cut, and the SIV market is still in trouble, as witnessed by the announcement of the Citigroup-JP Morgan-Bank of America-sponsored rescue plan, and the restructuring of some failed SIVs (Cheyne and Cairn).

In addition, the dollar has continued to fall against most currencies, and further interest rate cuts could lead to a rapid decline, which would also be destabilizing.

The Fed has only a hammer, in this case monetary actions (interest rate moves and liquidity increases or reductions) and therefore the current economic woes look like a nail. But the ailing housing and money markets will not be cured by looser monetary policy. Their problems are lack of transparency and insolvency. A 25 basis point cut, or even a 200 bp cut, isn’t going to put more cash in the pocket of someone who can’t make his mortgages payments, or make money market investors suddenly trust SIVs that hold mortgage-related paper.

The experts argue that the Fed has to cut rates this week because the markets expect it. Since when is making the markets happy the Fed’s job? (Whoops, I know the answer to that question: since Greenspan).

The role of the Federal Reserve, as William McChesney Martin put it, is to take the punchbowl away when the party starts getting good. In other words, one of its responsibilities is to deny the industry what it wants, because what it wants isn’t necessarily in its best interest.

Further consider that the Fed feels pressured to act because Fed fund futures have a rate cut priced in. Maybe the Fed needs to look at other markets to gauge the likely efficacy of its actions.

The markets have already discounted a rate cut, meaning they are well nigh certain it will happen. Yet the ABX indices, which are a increasingly reflect sentiment about the housing market have been deteriorating rapidly at the very time when confidence in a Fed cut this month has been rising (see yesterday’s update). If this free fall doesn’t prove the irrelevance of a Fed funds cut to the housing market, what does?

Both the Financial Times and Mark Thom’s Economist’s View provide insightful views. The Financial Times comment, by Manuel Hinds and Benn Steil is as close to snarky as the FT gets and ominously (and quite seriously) draws parallels between the US and developing countries that suffered financial crises (shades of our Banana Republic Watch), specifically, the combination of modest inflation in consumer goods and bubbles in investable assets.

Thoma features fellow University of Oregon prof and Fed watcher Tim Duy. Interestingly, at the beginning of October, Duy was predicting further rate cuts, even though he was opposed to the idea. He thinks they are unlikely for now based on GDP growth. He also shows that the Fed has communicated its views pretty clearly, but the financial media has turned a deaf ear.

First, from the Financial Times:

The Federal Reserve’s dramatic 0.5 per cent interest rate cut on September 18 was greeted with euphoria in the stock market, which soared 5 per cent in the two weeks that followed. This fact itself was hailed as vindication for a Fed that felt Jim Cramer’s pain, and gave the world the cheaper dollars the market guru shrieked for in CNBC’s (and YouTube’s) most memorable “Mad Money” segment ever.

To those who worry about inflation, the Fed could point to crunching credit as a danger to growth, and ipso facto a force for disinflation. Waiting for the numbers to prove it would just be reckless dithering.

We have sympathy for Ben Bernanke, Fed chairman, and company. The job of a price fixer is never easy. What should money cost? For most of human history this was easy: once you fixed a conversion factor with gold, you just sat back and let the forces of supply and demand do their stuff. But since the collapse of the Bretton Woods currency regime (the last vestige of thousands of years of commodity money), discretion has been the watchword. Nine smart folks at the Fed board have taken over the job of deciding what the price of money should be. If the hagiography and hatred showered on Mr Bernanke’s predecessor, Alan Greenspan, is any indication, that price should be wisely wiggled down to make jobs, up to prick bubbles and now, apparently, back down to offset losses on millions of bad credit decisions.

So, are our cheaper dollars now at the right price? In the coming months, all eyes will be on the consumer price index for the answer.

Unfortunately, there are circumstances in which excessive monetary creation can destabilise the economy while the rate of CPI inflation remains low. These tend to be present when the danger of monetary destabilisation is at its highest because people have lost faith in the ability of money to keep its value through time.

As one of the great monetary economists of the last century, Jacques Rueff, pointed out in the late 1960s, people react to the “growing insolvency” of a reserve currency, such as the dollar, by acquiring “gold, land, houses, corporate shares, paintings and other works of art having an intrinsic value because of their scarcity”. Sounds familiar? Indeed, this is the story of our present decade, one in which alternatives to the dollar as a store of value have soared even while the CPI has remained subdued.

This phenomenon is well-known in developing countries, where asset booms combined with low CPI inflation have preceded monetary and financial crises. In Mexico, for example, share prices rose 12-fold between January 1989 and November 1994, while inflation fell from 35 per cent to 7 per cent. Inflation then soared as the Tequila crisis exploded.

Prices of shares and real estate more than doubled from 1993 to 1996 in Indonesia and South Korea while CPI inflation rates were declining. In May 1997, just weeks before the currencies collapsed, inflation was only 4.5 per cent in Indonesia and 3.8 per cent in South Korea.

The same symptoms have been visible in many other monetary crises in developing countries. They seem to be visible today in the US. Following the 2001 dotcom crash, resources flowed into real estate, foreign exchange and commodities, while CPI inflation remained modest. In 2007 the housing bubble finally burst, causing credit to crunch as the market struggled to out the owners of dud mortgages and mortgage-linked contracts. The Fed reacted with cheaper dollars, which did precisely nothing in that regard. Credit risk fears remain unabated. But the market duly dumped dollars for harder assets, pushing the euro, shares, oil and gold to record dollar prices.

Gold, having been global money for the better part of 2,500 years, and therefore the commodity most sensitive to expectations of macroeconomic in stability, provides the best measure of the extent of the rush towards inflation-proof hard assets.

Between August 2001 and August 2007, the dollar price of gold soared 144 per cent, while the CPI rose only 17 per cent. The last time such a substantial and sustained appreciation of gold was observed was in the 1970s, on the heels of America’s loose money policy and balance of payments deterioration in the 1960s and Rueff’s warnings regarding “the precarious dominance of the dollar”. There were two episodes, from 1971 to 1975 and from 1977 to 1980. In both, the increase in the price of gold and other commodities presaged substantial increases in CPI inflation as well as significant falls in the international value of the dollar.

The dollar sustained its role as the international standard of value because of good fortune on two fronts. First, the Fed under Paul Volcker hammered out inflationary expectations with a painful but necessary period of high interest rates. Second, there was no viable alternative.

It may not be so lucky this time. Today, not only does the euro wait in the wings as understudy, but gold banks have risen in tandem with the dollar’s decline and offer the world a viable private alternative that has permanent intrinsic value.

As the Fed debates whether the world is truly crying out for even cheaper dollars, it would be wise to heed the lessons of monetary history.

Below, Tim Duy focuses on the fundamentals, as he argues the Fed will, and finds they do not justify a rate reduction:

The Fed begins a two-day meeting today, with market participants widely expecting a rate cut. I am mentally prepared to be on the wrong side of this call, joining the lonely few, but I just can’t tease another rate cut out of the incoming data.

In my mind, the argument for a rate cut hinges on one crucial assumption – that the market is expecting a rate cut, and the Fed will not want to disappoint…..

The problem with this view is that Fed Chairman Ben Bernanke does not believe it is his job to lead markets around by the nose like his predecessor. I think under the new regime, the Fed expects their comments to be taken at face value. And I think they are pretty effectively communicating their view on the economy: Outside of housing, there is minimal spillover, and whatever spillover exists is completely expected. From Bernanke on October 15 (italics mine):

Since the September meeting, the incoming data have borne out the Committee’s expectations of further weakening in the housing market, as sales have fallen further and new residential construction has continued to decline rapidly. The further contraction in housing is likely to be a significant drag on growth in the current quarter and through early next year. However, it remains too early to assess the extent to which household and business spending will be affected by the weakness in housing and the tightening in credit conditions. We will be following indicators of household and business spending closely as we update our outlook for near-term growth. The evolution of employment and labor income also will bear watching, as gains in real income support consumer spending even if the weakness in house prices adversely affects homeowners’ equity. The labor market has shown some signs of cooling, but these are quite tentative so far, and real income is still growing at a solid pace.

A week later, Chicago Fed President Charles Evans reiterated the outlook:

Indeed, on balance, I would characterize the data we have received on the real economy since the last FOMC meeting as supporting our baseline forecast.

Such comments – that the economy is roughly in-line with the Fed’s forecast – are essentially ignored by commentators. Has anyone noticed that the data flow has steadily caused 3Q07 estimates of growth to be raised above 3%? Think about it – the Fed cut rates 50bp during a quarter in which growth topped 3%, just after a quarter with almost 4% growth.

The Fed is never that proactive. Never.

Yes, I know, forecasts for 4Q07 are low on the potential impact of the August market turmoil. But note that we have almost no data on the 4th quarter to assess the quality of those forecasts; largely some volatile data on consumer confidence and jobless claims. Moreover, the Fed expects weakness, and is trying to look through it to mid-2008. And the Fed already cut 50bp because they knew that they would not have any good data on which to assess the 4th quarter at their October meeting. Nor would they normally commit to policy with only a single month’s data. The month is not even over! That was the “risk management” portion of their decision to cut 50bp in September. How many rate cuts do you take as insurance?

And, on risk management, Fed Governor Frederick Mishkin, one of the architects of 50bp move, sees financial conditions improving:

‘Market functioning has certainly not yet returned to normal,” Mishkin said in a speech at a seminar commemorating the 1907 U.S. financial panic, which led to the Fed’s creation. Still, Fed actions ”have helped improve conditions in several short-term funding markets and instill confidence in investors that liquidity would be available if needed,” he said.

They did not expect conditions to return to normal overnight; they are simply looking for things to be moving in the right direction. And they are – notice that the ABX market is coming unglued again, as documented by Calculated Risk, but the impact on financial markets is considerably more muted than this summer.

I also believe that this latest jump in oil prices will cause Fed policymakers to question their confidence in the inflation outlook more so than the growth outlook (if economic activity was really coming unglued, oil consumption should be slowing). And notice that despite a softer near term outlook for the economy, FedEx is still prepared to boost its air rates 6.9% next year, following this year’s 5.5%. They must be pretty confident of their pricing power. In my mind, the entire commodity complex is a worrying signal about the path of inflation, but I doubt the Fed is as concerned. Likewise the Dollar; I still have trouble believing the Fed has completely written off the Dollar, but continued rate cuts would signal that the Greenback remains a one-way bet…..

If the Fed decides they are unwilling to defy the market, or that “risk management” requires additional rate cuts, I would have to conclude that regardless of what the statement says, that one must expect a series of multiple rate cuts. They will be responding to the deteriorating housing market, and I simply expect no stabilization in that market in the near future….

Bottom Line: I believe the Fed intended to take a pass in October with the 50bp rate cut. I believe market participants were correctly reading the data until they got caught up in the risk management story. I think the Fed has been explaining past actions, not future policy. For that, you need to look at their forecast. On the basis on the data alone, the Fed is already so far in front of the curve it is hard to justify another cut at this point. I absolutely do not expect the Fed to cut 50bp.

This is the most contrarian call I have made; I simply believe that the case for a rate cut is much weaker than market participants appear to believe.

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  1. a

    My 2 cents…

    Policymakers like generals fight the last war. The last war here is the Great Depression. Greenspan didn’t want to be known as the guy who caused the Second Great Depression, so he lowered rates whenever he felt deflation and depression was a threat.

    Bernanke has been dealt a losing hand. The U.S. economy is going to get poorer no matter what he does. If it goes into recession, poverty increases. And if it doesn’t go into recession, it will (IMHO!) be because foreigners start spending their dollar hordes and keep Americans working. But those goods shipped abroad will be less goods for Americans; Americans themselves will still be poorer. So whatever Bernanke does is wrong; he can’t win.

    The choice, I think, is who gets poorer. If Bernanke lowers rates, everyone but the financial sector will get poorer, as lower rates will give more time to the financial sector to off-load their losses onto others. That is, the financial sector losses are minimized and the rest of the nation’s losses are mazimized. And so that’s why I think he should hold the line on rates, as the guilty party in this debacle should be suffering the most, not the least.

  2. Jeremiah

    agree… if the Fed sticks to its mandate, then taking all the risks into account (including the money market distress, and the SIV mess) it SHOULD NOT LOWER RATES
    the falling dollar should be reason enough not to ease rates; on the other hand Mishkin said that there is no evidence so far that the weaker dollar has any meaningful influence on inflation. and this confuses me.. it might not have had a meaningful influence on the official statistics for some reason. either due to adjustments or simply because companies are slow to adjust prices.

    BUT when the dollar falls in value, it means that whatever you want to buy with your dollars thats coming from outside the US you can buy less of it, unless foreign companies lower the prices in their own currency. but there is no evidence of that happening.

    so just as the Fed took out insurance against further distress in the money markets, it should take out insurance against a falling dollar by at least leaving rates unchanged. if they stick to their mandate.


  3. Anonymous

    During the eighteen years of the former Fed governor tenure the foreign exchange market has been manipulated with all possible combinations (a lower dollar in an up trend economic cycle, a stronger dollar in a softer economic cycle) the end result was an aggravating balance of payment deficit with a steadfast propensity to consume nurtured by asset appreciation and capital gain dependant US consumer.
    The foreign exchange is not a priority, savings, investments are the issues and lower interest rates will not help to encourage the domestic savings, large corporations have enough money in their coffers as they can indulge themselves in financial engineering (650 Billion USD in shares buy back) money is plentiful if corporations which are indebted are invited to repay their loans.
    Solvency will not be helped if there is a decreasing interest rates with no incomes or an unsustainable income /debt ratio.
    Conclusion no need to change the interest rate today, but there is an emergency to rebalance the fiscal policies, the supply and demand of money, the personal income of the various class of the US society .
    Inflation is made as a low priority since it does not include food and energy, this penalty on low incomes cannot be the benefit of Wall street.

  4. Jeremiah


    you save too little = you consume / import too much
    so you drive up the price of goods and services because you absorb too much domestically.
    the market is then devaluing the currency, because this is the price the rest of the world requires to make up for the US’s domestic dis-saving
    you need to KEEP RATES HIGH to encourage saving (public and private). this will improve the external balance and keep inflation from rising. the currency from depreciating.
    you will have a loss in output though, which obviously is taboo..

    instead, you cut rates to keep it going. while fiscal policy is lose already.
    usually, recipee for a disaster.

    but all of the above is ‘old school’
    now its different.. im being told(sarcastic)


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