What Interest Rates are Telling Us About the Outlook
The Federal Reserve Disappoints Wall Street
By blackhedd Posted in Economy | federal reserve | inflation | Interest rates — Comments (32) / Email this page » / Leave a comment »
You've read the headline: the Federal Reserve Open Market Committee, meeting in Washington yesterday, announced a cut in short-term interest rates. The "fed funds rate" will now be targeted at 4.25%, down 25 basis points from the 4.50% rate that was announced in October. The Fed also cut the "discount rate" (at which banks may borrow money directly from the Fed) by 25 basis points.
The moves had been carefully telegraphed and were no surprise. But to say that Wall Street was disappointed is understating the case. The stock markets sold off on the news, with the Dow Jones Industrials Average dropping about 350 points from where it was when the Fed's announcement came out in mid-afternoon. And the bond market soared. There was actually a lot of anger out there.
What happened?
More...
Wall Street had been hoping to see the Fed take a far more aggressive stance toward economic growth. Many people wanted a full 50 basis-point cut in both the fed funds and the discount rates, together with signals that more rate cuts would be coming at the FOMC's next meeting on January 29. Instead, the Fed delivered only 25 basis points, and their accompanying policy statement was ambiguous and carefully-hedged.
It's now received wisdom that the US economy is in terrible shape and heading for even worse trouble. The main reasons for this are the twin crises in housing values (which is thumping the construction industry) and in the credit markets (which is putting the hurt on Wall Street firms).
In addition, the perception is taking hold around the world that the United States has let the wind out of the sails of the global economy. I think this is mostly because of the distress in the market for securities backed by US mortgages, including subprime mortgages. Of these securities that were issued during the recent US housing boom, it turns out that many, perhaps most of them, were purchased by investors in Europe.
So economic analysts (and television talking heads) the world over have been setting expectations for a big slowdown in US economic growth. Measurements of consumer confidence (which are believed to foretell future spending by consumers) have accordingly nosedived in recent months. And if the 1992 Presidential campaign is any indication, we can expect Hillary Clinton to start telling us that conditions are now worse than during the Depression.
That has led everyone to look to the Federal Reserve, which wields the big interest-rate policy lever, to ride in and save the day with floods of cheaper money.
The Fed obviously was reading different tea leaves from everyone else. What do they think they see that no one else does? Inflation.
The Federal Reserve consists of a powerful Board (of which Ben Bernanke is the chairman, named to four-year terms by the US President), with nearly twenty governors named to fourteen-year terms. And also there are twelve Federal Reserve Banks, each serving a different region of the country. (Go look up the cities in which they're located sometime: it's an interesting exercise in seeing where economic activity was concentrated a hundred years ago, when the Fed was established.)
The Fed's leadership has a lot of top-quality economists (Bernanke is one), but it also has a lot of experienced bankers. And of course since the Fed regulates the banking system, they're talking to bankers and business leaders around the country on a daily basis. They're in a very good position to know what economic and credit conditions are really like out there in the world, far away from Wall Street's analysts.
Now the current crisis in credit markets is of course very severe, with many people in agreement that things are at least as bad now as they were during the liquidity shock last August, if not worse. And an interesting thing happens at this time of year: the demand for liquidity is considerably greater than usual, because banks and investment firms are closing their books, and they need to prove that their reserve levels are adequate. All else equal, this has the twin effects of raising short-term borrowing costs, while also making capital unavailable for business expansion.
I heard Wall Streeters express anger that the Fed didn't take this seasonal effect into account when deciding on the size of their rate cut. (Additionally, they were surprised that Fed officials, who were kissing ears all over the Street back in August, apparently weren't telephoning around as much this month.)
But this is something of a red herring. A few days ago, the Fed quietly issued a large set of repurchase agreements (their favored tool for adding short-term liquidity) expiring early in January, precisely to make sure that conditions are orderly during the year-end closing period.
The Fed did two things this week. They examined current economic conditions with a view to the whole economy, not just credit conditions or corporate earnings. And they looked at the outlook for the near-term future.
What they evidently saw was that the economy continues to show surprising strength in the face of the decline in housing values in many parts of the country. Consumer spending is not down as much as many had predicted, and job creation is also quite strong. The US economy is more demand-driven than any other large economy in the world, and if consumers are taking a breather, it's not showing up in the data.
The Fed also saw high and worrisome signs of inflation. I've said often enough here at RedState that the US is the only large economy in the world (except Japan) not suffering from significant inflation. Well, we apparently are now as well. The Fed prefers to measure inflation by looking at consumer prices minus food and energy costs. (In Europe, they use monetary aggregates like M2 and M3.) And there are indications that consumer prices may grow in the range of 2.6 to 2.9 percent next year. That's far above the Fed's target range of 1 to 2 percent.
The outlook, on the other hand, is extremely unclear. If we really are in an economic slowdown, we won't see it until this quarter's economic data come out next year.
Taken together, the strong economy and the high inflation account for the smaller-than-hoped-for rate cuts. The uncertain outlook explains why the Fed chose not to send a clear signal on where rates are headed.
Based on my conversations in recent weeks, I think the Fed is more likely to be right than wrong. I see relatively little deterioration in business conditions, as companies in export sectors ramp up production. Emerging markets continue to generate a lot of demand for our goods and services. And although the financial sector is in a deep blue funk, one measure of Wall Street's true state of health is flashing bright green: tax collections by the government of New York City. Bonuses will be just as high as ever this year, and the New York's budget is actually in surplus.
I also think there is a good likelihood that, after yesterday afternoon's loud Bronx cheer, financial-market players will take a second look at the Fed's actions. And they might even do a little buying.
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This is perhaps the most important part;
What they evidently saw was that the economy continues to show surprising strength in the face of the decline in housing values in many parts of the country. Consumer spending is not down as much as many had predicted, and job creation is also quite strong. The US economy is more demand-driven than any other large economy in the world, and if consumers are taking a breather, it's not showing up in the data.
The Street always seems to react emotionally first and hedge against the worst scenario. Right now futures are up with the news of potential discount window moves and actions to help manage liquidity. My take is short term bumps potentially until Spring. However, longer term things will be fine. Oh yeah and Hillary, Obama et al should sit down and shut up. They probably don't even manage their own portfolios well - that is except for Hillary's past little commodity miracle.
"Dulce et decorum est pro patria mori"
Contributor to The Minority Report
Of course you were being hyperbolic :-), but it's worth pointing out that Obama is not a wealthy man. Even if he were, as a Presidential candidate he shouldn't be managing a portfolio because of the potential conflicts.
Ditto with Hillary Clinton, who proved that corruption isn't enough to get rich. You have to be smart too. As long as she stays married to that lying sack of excrement her husband, she benefits from the spectacular earning power he acquired the day he left the White House.
snarky and probably poorly phrased. However, my point was they don't, nor could they (manage their money without significant help)and have never run anything. Yet they will tell us all about the right way to run this economy.
Hillary got about $8 million from her book and is estimated on her own to have a net worth between $10-50 million. Obama is somewhere between $1.5 - $2.5 with much of that from his book; certainly not Hillary money but nonetheless not bad.
"Dulce et decorum est pro patria mori"
Contributor to The Minority Report
Do you (or anyone else) know if she has moved her portfolio to a blind trust? I'd dearly love to know what she's been buying, if anything. (And how much of it is in a large East Asian nation that I promised myself I wouldn't mention for a change.)
As far as Obama is concerned, $2 million isn't even enough to get into a hedge fund. If I were him I'd just be buying stock-index funds.
I remember seeing this. UST's and "cash" now. Hmmmm.
"Dulce et decorum est pro patria mori"
Contributor to The Minority Report
"The Clinton's, the only people that could make an aggregate 20 Million writing memoirs about things they couldn't remember on the witness stand."
Don't forget, TheHill™ got 8 but BillyBoy™ got 12.
The HinzSight Report
Managing Editor
I'm always impressed by both your knowledge and your ability to convey what you know in clear terms.
Despite the gloom and doom, it's just not there.
Housing market and credit is extremely tough, but i believe the nasdaq is still up 8% for the year, the US is creating jobs and because of the weak dollar, the US is actually exporting more goods and salaries are increasing. i mean, some indexes have increased by 30% since 2005; you can't expect that to continue without a major economic change like the dot com boom.
its going to be tight for a while, but most experts would agree the worst of the housing and credit are behind us; and with growth in many economic sectors; it will continue to pull out of the current slow period.
although, cnbc is somewhat of a market cheerleader; i recommend watching kudlow and company. kudlow gives a pretty good analysis of the market and economy on a daily basis and interviews bulls and bears for different perspectives.
...principle to avoid television news and business reporting, the WSJ, and similar things.
I do catch Larry on the radio occasionally. He is a cheerleader, but at least his reasoning is always sound.
do you make it a point to avoid the WSJ? And where DO you get your news from?
I occasionally watch Kudlow, and he is quite the market cheerleader. He rooted for two things with the fed rate cut. First, he said the fundamentals of the economy are strong and that the Fed doesn't need to cut. However, he says the Fed will cut, and that it should cut 50bp and end these incremental rate cuts which create an incentive for borrowers to hold off from taking a loan until the rate cuts end (so they receive the lowest possible rate), in order to speed our recovery and reliquify the credit markets.
I like the WSJ for inside looks into Wall Street and corporate America, but I think Bloomberg provides the best fact-based news. Bloomberg makes it easy to follow the primary economic indicators and provides the data that actually move markets. The WSJ gives this data in many more words.
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And statesmen at her council met
Who knew the seasons when to take
Occasion by the hand, and make
The bounds of freedom wider yet
- Tennyson, _To the Queen_
True, though I'm not referring to their subscription services. The news and data they provide on their website for free are still highly informative and straightforward in their presentation.
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And statesmen at her council met
Who knew the seasons when to take
Occasion by the hand, and make
The bounds of freedom wider yet
- Tennyson, _To the Queen_
I read Bloomberg, FT, and various rags on trading and institutional investing. But mostly, I talk to people.
I like reading Forbes magazine but I rarely waste time on Fortune or Business Week. Years ago I read the Economist and Barron's. I stopped reading them when I realized that both have an uncanny knack for drawing the wrong conclusions. The same is true with Business Week, for example, but the Economist and Barron's are so well-written that you're fooled into thinking they know what they're talking about. ;-)
I started reading the Economist again recently, but only because everybody swears by it. Sure enough, they ran a cover that showed the dollar going down in a flaming aircraft... at the end of the precise week when the dollar stopped falling.
If inflation is really chugging along at almost 3%, how could the deflator for last quarters GDP be only .7% (the lowest in over a decade)? I believe that we are probably headed towards a drastic slowdown and could end up in a mild, but lingering recession due to the housing/credit problems as consumer spending will likely slow after the holidays.
Artificial manipulation of the interest rates is going to harm us eventually. Capital can't be created out of thin air, it can only be produced by one person delaying consumption of their production and allowing someone else to consume that production instead. Thus interest rates should operate on a principle of supply and demand just like every other economic price for a good or service.
I'm not suggesting that the market is zero sum.
Interest rates are almost all set by free markets. The only one that isn't is the one at the Fed's discount window, which is not a heavily used facility to begin with.
Even so, the discount rate is invariably set at some premium above the fed funds rate, which is set by free markets.
The only thing the Fed does is to engage in open-market operations in New York every morning, to nudge the fed funds rate close to its stated target.
The Fed performs an elaborate minuet with the markets in regard to interest rate targets, and all of its activities for that matter. The opinions and the condition of Wall Street matter tremendously to them. At the same time, they go to great lengths to avoid giving the perception that they are controlled by Wall Street.
But at the end of the day, the Fed can't set interest rates that diverge from reality for long periods of time, any more than the Treasury can manipulate the value of the dollar.
Right now savings are at an all time low; if the interest rates were set by the market free of government intervention one would except a high rate of interest. This doesn't happen because there is an infinite supply of capital being provided by the Fed at a fixed low rate.
The treasury can manipulate the value of the dollar just by contracting or expanding the money supply. No one knows how much the money supply has risen beyond the actual value of goods and services in the net economy (they stopped releasing those figures), but it is probably something over 10%.
BTW, I already know what they claim that they're doing, but anyone who knows anything about economics isn't going to be fooled.
Savings are at an all-time low because consumers are rational. The bank doesn't pay you enough interest to counteract inflation, and the growth opportunities are elsewhere anyway.
Large businesses in the US are no longer funded primarily from bank credit. They have access to commercial-paper and money markets. Consumer savings rates are not the primary determinant of market interest rates.
In fact, interest rates around the world are extremely (and unaccountably) low. It's not because anyone is manipulating rates. It's probably because global investors have too much money and not enough good places to put it. An extreme case of risk-aversion after this summer's crisis is making rates even lower yet.
The Treasury has absolutely nothing to say about the money supply. That's the Fed's job. The Treasury can borrow money on behalf of the government, but (except in times of total war) they have to pay the market rate of interest.
The Treasury can try to manipulate the exchange-value of the dollar, but the markets know that trick. And the markets are far bigger than the Treasury.
The Fed takes the value of the dollar into account when they set interest rates. Of course you noticed that the dollar's value barely moved against the euro and the yen yesterday. That tells you that the rate change was fully anticipated by the market.
The Fed very rarely makes permanent changes to the money supply. The last one I saw was in April.
"Savings are at an all-time low because consumers are rational. The bank doesn't pay you enough interest to counteract inflation, and the growth opportunities are elsewhere anyway."
That's correct, but it doesn't comprehend the reasons why this is the case. In a free market if you have low savings then there will be little capital available for those who want to borrow and thus interest rates will rise and people will begin to save. This process is short circuited when the Fed keeps interest rates low and provides capital to the market via its ability to make loans that are not backed by delayed consumption elsewhere in the economy. This is also the main source of our current inflation (loans without concurrent delayed consumption).
"Large businesses in the US are no longer funded primarily from bank credit. They have access to commercial-paper and money markets. Consumer savings rates are not the primary determinant of market interest rates."
Where does the money in these sources come from? Commercial paper is typically issued by big banks or large corporations. Its possible that delayed consumption backs the funds from large corporations, but big banks are making their loans without real value backing them, since, as you point out, they're not getting it from savers anymore. Some money market participants issue asset backed notes, but as we've seen with the housing market decline those assets are not often appropriately valued. The economy is all intertwined; if you pump money into one end its going to affect everything else eventually. Artifically cheap interest drove unrealistic consumer consumption, most noticably in the housing market, but now its coming to an end (regardless of the government stepping in even more directly to freeze rates for five years).
"The Treasury has absolutely nothing to say about the money supply. That's the Fed's job. The Treasury can borrow money on behalf of the government, but (except in times of total war) they have to pay the market rate of interest."
You're splitting hairs without making a point.
"The Fed takes the value of the dollar into account when they set interest rates. Of course you noticed that the dollar's value barely moved against the euro and the yen yesterday. That tells you that the rate change was fully anticipated by the market."
The market is a big ship, it takes time for things to move. Right now the market is still full of confidence that the Fed can manipulate some kind of endless prosperity. The Euro and the Yen are similarly under heavy manipulation so their relative strength to the dollar is immaterial in the long run. What matters is the dollar's strength against goods and services in the economy and there is far more inflation out there than is illustrated in Clinton's modified CPI.
"The Fed very rarely makes permanent changes to the money supply. The last one I saw was in April."
How would anyone know, they've stopped publishing the M3 figures so all we can do is guess.
and it has nothing to do with fed rates. That, and a fundamental shift in the average person's access to the markets via mutual funds, especially for retirement.
At the time that the accepted TrueFact (TM) of credit coming from savings was in point of fact true, the average (think mode or possibly median, certainly not mean) person planned for retirement (including wife and family since it was usually the man at that time) by saving, working at a place with a good pension plan, and maybe investing in a whole life insurance policy. Investing in the stock market meant visiting the hoity-toities and buying single stocks (lot of 100 or there will be an extra fee) and if you couldn't invest in at least 5 stocks you weren't even marginally diversified to survive a potential market fall. So you simply couldn't afford to go there. These days I send my semi-monthly 10% to a mutual fund. It never hits a savings account because savings can't ever match the return of the market even if you assume no federal control. Savings pay lower because there is no risk to the capital, so youn'ins like me are always going to go for the market over even bond funds let alone savings accounts.
As I read this, you're starting with a particular view of macroeconomics and you're trying to relate it to specific questions of how real markets work. That would explain the impedance-mismatch in many of your points.
From where I sit, I see huge amounts of capital in the world, and not nearly enough good credit, a situation that has obtained for most of the past ten years. You insist on relating this to consumer "saving," but you're so committed to the idea that there is no capital out there that you seem to be ignoring observable reality.
Unless you're saying that all that capital out there is really not there, and created entirely by Fed manipulation. Is it possible that you think credit isn't real unless there's a commodity behind it?
The market is indeed a big ship, but it moves at the speed of light. If the Federal Reserve were ever to surprise people with a move on interest rates, you'd see it reflected in currency exchange rates in negative time. (Why negative instead of instantaneous? Because the expectations would inevitably leak out ahead of the news.)
Commercial paper: when a bank or large business issues paper, they're borrowing money. That whole paragraph sounds like you understand money markets in reverse. I'm obviously misreading you.
Splitting hairs without making a point: is that the best you can do? You made an incorrect statement. The Treasury Dept has its own job, and it doesn't do the Fed's job.
Permanent changes to the money supply: the Fed publishes all of their monetary operations. The days of secret Fed operations ended early in Greenspan's tenure. They don't publish M3 anymore because they've decided it's meaningless and too hard to measure.
"As I read this, you're starting with a particular view of macroeconomics and you're trying to relate it to specific questions of how real markets work. That would explain the impedance-mismatch in many of your points."
You're starting with a particular view too; again you make a meaingless point. If you have an opinion it should be on some kind of factual and philosophical position.
"From where I sit, I see huge amounts of capital in the world, and not nearly enough good credit, a situation that has obtained for most of the past ten years. You insist on relating this to consumer "saving," but you're so committed to the idea that there is no capital out there that you seem to be ignoring observable reality."
I see huge amounts of capital too, but none of it is the result of delayed consumption. Savings doesn't have to be a CD account; any form of delayed consumption is acceptable (stocks, bonds, etc).
"Unless you're saying that all that capital out there is really not there, and created entirely by Fed manipulation. Is it possible that you think credit isn't real unless there's a commodity behind it?"
Bingo. What do you think delayed consumption means? Someone has to work and produce goods/services and then not consume them in order to create real capital that can be put toward another investment. If the Fed creates money out of thin air and loans it out then the person borrowing consumes goods/services and so does the person would didn't save (by some means, be it CDs, stocks, or whatever delayed consumption they decide to use). This double consumption is what causes inflation and market bubbles.
"The market is indeed a big ship, but it moves at the speed of light. If the Federal Reserve were ever to surprise people with a move on interest rates, you'd see it reflected in currency exchange rates in negative time. (Why negative instead of instantaneous? Because the expectations would inevitably leak out ahead of the news.)"
This is again partially true, but mostly wrong. It takes a considerable amount of time for market indicators to filter out into the economy at large. When money starts to move on Wall Street its a long time before I see the consequences in my own pocket (unless I happen to own stock that goes up or down dramatically, and maybe not even then).
"Splitting hairs without making a point: is that the best you can do? You made an incorrect statement. The Treasury Dept has its own job, and it doesn't do the Fed's job."
The Fed is an instrumentality of the federal government just like the Treasury Dept. Simply because the Fed has another layer of quasi-independent bureaucracy between it and the politicians doesn't make it any less a government actor. Thus trying to pretend that the government doesn't have anything to do with the Fed's manipulations is inherently deceptive.
"Permanent changes to the money supply: the Fed publishes all of their monetary operations. The days of secret Fed operations ended early in Greenspan's tenure. They don't publish M3 anymore because they've decided it's meaningless and too hard to measure."
The M3 measure was showing a huge increase in the money supply totally divorced from any economic reality; that's why they stopped reporting it. Last I checked the Fed doesn't keep detailed minutes of their meetings either so I have no idea what you mean by the supposed end of their "secret operations."
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Finrod's First Law of Bandwidth:
A picture may be worth a thousand words, but it takes the bandwidth of ten thousand.
I've gotten the impression that low intrest rates weaken the dollar. Good if we can sell a bunch of exports; poor if we base our prosperity overwhelmingly on domestic consumption...
"If this ain't a mess, it'll do until one shows up." -Sheriff Bell, No Country For Old Men
...back around 2003 or so, when the Greenspan Fed started the round of rate increases that ended last year. You could look it up.
This past August when things were wild and crazy, I saw fed funds go as low as 1% on several occasions, and as high as 6%+.
Not as wicked as the rate swings during the last financial crisis before the Fed came along. During the Panic of 1907, the broker-call rate fluctuated from near-zero to 75% or more. During some hours, money was unavailable at any price. Preventing that kind of disaster is the biggest reason the Fed was established in the first place.
I am upset that the Fed decided to cut rates at all. The economy is not strong right now because of the sub-prime morgage crisis and it hasn't been terribly strong since the 90s. But the way to fix it isn't always to have the fed cut interest rates. The Fed Chairman himself said he was worrying about inflation. With all these rate cuts it can drive inflation and just like in the 1970s when the Fed wanted to try and slow unemployment by cutting the discount rate.
Sometimes the economy needs to sort itself out or it could result in the same effects as in the 70s with high inflation. A recession is not always a bad thing in the long term, the government can't always manage the market.
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Notice to All - I am an independent who has voted for Senator Bayh (Democrat) and Senator Lugar (Republican) along with over 60% of my state. You may take what I say with a grain of salt at your own party'
In fact I wish they hadn't cut rates at all... maybe even increased them.
There are sure a lot of doom and gloomers out there on the US economy. They show up every single time the stock market pulls back a few percent. But they're wrong. Slow growth is not a recession. Slow growth is slow growth. The country is at full employment and inflation is low. The drag on the economy is coming from high energy prices (due to growth in world economies and increasing demand) and the real estate recession.
But overall, things are fine and I believe stock market corrections are good buying opportunities.
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muckdog
http://thelearningcurve.blogspot.com
(GW doomsayers to the contrary).
The financial arrangements surrounding it may have to be substantially reworked, but the properties are still there. We are not having something like the dot-com bust, where both assets and valuations were a mirage.
Excellent reportage as per usual, blackhedd.