Markets Want Christmas in January (Rate Cuts Edition)

Although a good deal can happen between now and January 31, the date of the next Fed Open Markets Committee meeting, a 50 basis point rate cut looks more consistent with present economic conditions than do deeper cuts. Most important (and widely ignored) is that the seize-up the money markets is largely a thing of the past (and let’s hope it stays that way). Interbank rates, particularly the much-worried-over three month Libor, indicates banks are lending to each other on more-or-less normal terms.

But as we know, the Fed has also shown itself to be unduly susceptible to what might politely be called the views of market participants, or more pointedly, lobbying by interested parties. And that lobbying takes many forms, including the Fed funds futures rates.

With no threat of imminent financial market crisis, the case for cuts rests (or ought to rest) on the economy. Greg Mankiw points out the obvious: since Bernanke came out in support of a fiscal stimulus package, he must believe it works, which implies monetary wheel-greasing should be reduced correspondingly.

Tim Duy argues at Economist’s View that less may be more. Note that Duy does not give much weight to the consideration that a fiscal package ought to moderate the level of rate cut required. He instead focuses on how the upcoming choice-points fits in with the Fed’s medium-term objectives:

I have already argued my position that the Fed’s medium and long run forecasts imply a neutral Fed Funds rate in the range of 4.0 to 4.5%, and that the Fed would like to anchor expectations around that range. They do not want to continue the policy see-saw of the last decade.

My next assumption is that the flow of economic data will tend toward weakness for the first part of this year and that the Fed will find it virtually impossible to resist responding to that weakness. That argues for continued rate cuts for at least the next four meetings….

My final assumption is obvious – no amount of rate cutting now will have any affect on the flow of data in the near term. Fed Chairman Ben Bernanke knows this; hence his support for immediate fiscal stimulus…

If the Fed pulls the trigger on 75bp at the end of next week, they will be on the path to a minimum of 150bp in the first half of this year – 75bp in January and 25bp in the each of the next three FOMC meetings (I think 100bp is more consistent with the Fed’s supposed policy objectives). This would go along way to meeting the Goldman Sachs call of 2.5%, or a full 200bp below the Fed’s estimate of neutral and 275bp below the last peak. The see-saw continues and any efforts to tie policy to their supposed medium and long term objectives are essentially meaningless.

Of course, the Fed could reverse course rapidly in the latter half of this year, unwinding the excess stimulus. Personally, I have virtually no faith in the Fed’s willingness to reverse rate cuts – regardless of the rate or direction of inflation – during a period of economic weakness.

Moreover, while the negative tone of recent data continues relatively unabated, it is not quite as dismal as the business press would lead us to believe. Not that I see roses where others see weeds. Instead, I sense that tenor of the data speaks more to 50bp than 75bp even if the Fed intends to front load additional policy. The industrial production report was not yet consistent with the ever increasing recession calls (although the Philly Fed report was decidedly weak). Nor was the most recent read on initial unemployment claims, which should be accelerating if we are actually in recession.

I had a similar reaction to the retail sales report as Jim Hamilton. Wasn’t great by any means, but not the end of the world either. But I wasn’t excited by the November strength in retail sales in the first place, and the December numbers are largely just matching my expectation that consumer spending looks finally to be ratcheting down. Indeed, January’s rise in consumer confidence is consistent with year-over-year growth of real consumer spending somewhere around the 2% rate I keep expecting to see and is inconsistent with economic freefall. Finally, the drop in the inventory to sales ratio in November is very inconsistent with the recession story.

Then there is housing. I have no need to comment on the state of the housing market itself – the numbers speak for themselves and are a significant part of the reason that the Fed will be induced to continue cutting interest rates.

Not to say that there is no argument for 75bp. In the grand scope of things, what’s another 25bp, especially if you expect to cut rates at least that much anyway? And while in December the Fed was sufficiently confident of their outlook to disappoint market participants looking for the more aggressive of the rate cut options at the time, they may not feel the same liberty given the renewed market instability we have seen this week.

Grr. While Duy may be right that the Fed capitulates due to fear of spooking the markets, the Fed should not care one iota about the equity markets. As for the credit markets, the spooked responses this week were due to specific events – worse than expected writedowns at Citi and Merrill, and the death spiral of MBIA, Ambac, and smaller bond insurers. Rate cuts would have no impact on the reaction to those developments.

Yet the markets are demanding more. The Cleveland Fed provides its update on market expectation as implied in Fed Fund futures (hat tip Calculated Risk); this chart shows that the odds of a 50 basis point cut (3.75%) and a 75 bp reduction (3.50%) are now almost equal, at roughly 40%. The market believes the odds of a 100 bp cut are 20% and a 25 bp cut, zero.

So why are the markets so insistent on deeper cuts, aside from the fact that they may correctly believe that aggressive lobbying for them via Fed fund futures might get them their way? The Financial Times gives us an answer in its editorial today, “Help! The credit crunch is finished“:

The short-term gloom may be overdone. Companies, which are less reliant on the credit markets than private equity, still seem willing to buy each other: brewers Heineken and Carlsberg have just raised their bid for Scottish & Newcastle to £7.8bn.

Nor has the great machine recycling the trade surpluses of China and the Gulf nations into US assets broken down. If anything, it has stepped up a gear, providing billions of dollars in new capital to US banks such as Citigroup and Merrill Lynch. Unless halted by currency appreciation in China or a protectionist backlash in the US, this activity will buttress stockmarkets and the US economy.

But asset valuations in western markets are still at precarious heights. Equity markets reflect corporate earnings that are close to the peak of the economic cycle and at record highs as a share of economic output. Real estate prices in the US and Europe are well above their historical averages in relation to earnings or to rents. A US recession in 2008 is still a chance and not a probability, but if one does arrive, asset prices can fall a great deal further.

For those with money to invest that is good news: pension contributions will buy more shares, bonds and property. In the short-run, however, more pain may be in store.

Translation: even at their current reduced levels, many types of assets look overvalued. Martin Wolf, the Financial Times’ highly regarded lead economics editor, said as much of the stock market in March 2007 (and recall that the Dow was then, as now, flirting with 12,000). His entire article is worth reading, but here are the key bits:

Any long period of market stability encourages speculation. Taken to excess, such risk-taking, particularly when fuelled by huge amounts of borrowing, can create significant instability. At a time when asset markets are generally buoyant and risk premiums low, the need for a reminder of riskiness is valuable….

The chart, taken from data prepared by London-based Smithers & Co, shows the actual and the cyclically adjusted price-earnings ratio of the Standard & Poor’s composite index since 1881. The cyclically adjusted measure follows the method of Professor Robert Shiller of Yale university: it is the ratio of stock prices to the moving average of the previous 10 years’ earnings, deflated by the consumer price index. The picture shows that the actual p/e ratio is now very close to its long-run mean of just over 15. The most recent cyclically adjusted p/e ratio, however, is 26.5, or about two-thirds above its long-run average. It is not as astronomically high as in 2000, but it is very high, by historical standards.

So let us not kid ourselves. No matter what spin is presented, the various stimulus measures look more and more to be about shoring up asset values. Not that that is surprising. But if that were more openly presented as the operative reason for various initiatives, we could have more open discussion and analysis of how desirable a course of action that really is.

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One comment

  1. Carl

    I agree that shoring up the asset values is the main thrust of the effort to stimulate the economy. The measures proposed would slow the collapse of such values if and only if they arrived very soon, which is very unlikely. So I would suspect that the decline in housing values specifically will be much faster than most are predicting, resulting in much more stress on the banks which are going to wind up owning far more inventory than they ever thought. This is not a good long term situation and will result in very high losses and further write downs. The social stresses are rising and with that real consumers are becoming more cautious in there spending. Lots of empty houses owned by banks and deteriorating neighborhoods are not an inducement for consumer confidence.
    The end of the credit crunch, while welcome and a necessary precondition for any sort of recovery from the ongoing housing mess, is not sufficient to reverse years of bubble blowing by a virtually unregulated and unrestrained lending system. I think the credit crunch is just taking a little vacation and will be back to work much sooner than is anticipated.

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