Thursday, August 13, 2009

Watching The Federal Reserve


Ever since the Federal Reserve realized that the economy was tanking [a couple years too late] and dropped interest rates that they had just finished raising to fight inflation [when dropping prices portended possible deflation], the Fed has been sitting quietly in the background doing banking "stuff" with banks that were have problems doing their banking "stuff."

The Fed has seen itself as the guardian of our banking system, whereas the rest of the nation has thought of it as the stabilizer of our economy. Not so much. As long as banks were solid, the Fed's whipsawing of our economy [which increased in frequency after 2000] was seen as a necessary action to prevent our economy from overheating or freezing.

The reality was that the Fed was trying to protect banks from the dilution effects of inflation on their loans and assets whenever the economy was growing fast enough that demand caused price increases. On the flip side, if the economy was slowing and bank profits were thinning, then a bit of rate dropping was in order. If that benefitted the economy, that was a nice side effect.

It wasn't until the Fed's last series of interest rate hikes [on the erroneous fear of inflation] starting in 2004 exacerbated a developing financial crisis that people began to notice something amiss. With the housing market collapsing followed by energy prices crushing the economy, why was the Fed still focused on raising interest rates?

Certainly, interest rates were not high in absolute or historical terms, but they were increased so quickly that individuals and business were caught in a large relative increase in costs. Money borrowed on equity was subject to variable rates that followed the Fed's rates. Suddenly those home improvement loans because home wrecking loans. And small business owners that used their home equity for loans to increase their businesses found themselves in a cash flow crunch. The rush of loans being defaulted caught banks and the Fed by surprise. This was not supposed to happen just because of manipulations to protect banks against inflation.

In 2007, while the Fed funds rate was 5.25%, I thought that a quick, decisive cut to 4% might restore some confidence that the Fed was on top of the situation... with more cuts to follow as necessary. A few months later the Fed cut the rate to 4.75% which only triggered dismay. Another cut a month or so later to 4.25% was now too little too late. It triggered panic as people were convinced the Fed simply didn't understand the scope of the problem. From that point on, the Fed was in a canoe following the tidal wave of collapse. There was nothing it could do.

The best laid plans....

Now there are rumblings about possible Fed actions to raise the funds rates. Well, they are at 0% so it is difficult to lower them. The question is: when is it appropriate to return rates to a more "normal" level and how fast? The last part of the question is even more important than the first part. Given the huge value losses of real estate and investments, at what point do we say everything is "normal" again? When the DJIA reaches 10,000? When home foreclosures return to the average rate of the past 10 years? When unemployment falls below 6 percent?

That's the big question for the Fed: when and how fast should the economic brakes be applied? There is no more accelerator for the Fed to press, so all the Fed can do is apply the brakes. How much slower should the economy go from here?

Go to the very bottom of this column to read some excerpts from blog posts going back to the beginning of 2006. It explains much. You can also do a blog search on "Federal Reserve" using the search box at the top left.


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Tracking Interest Rates

Tracking Interest Rates


SEARCH BLOG: FEDERAL RESERVE for full versions... or use the Blog Archive pulldown menu.

February 3, 2006
Go back to 1999-2000 and see what the Fed did. They are following the same pattern for 2005-06. If it ain't broke, the Fed will fix it... and good!
August 29, 2006 The Federal Reserve always acts on old information... and is the only cause of U.S. recessions.
December 5, 2006 Last spring I wrote about what I saw to be a sharp downturn in the economy in the "rustbelt" states, particularly Michigan.
March 28, 2007
The Federal Reserve sees no need to cut interest rates in the light of adverse recent economic data, Ben Bernanke said on Wednesday.
The Fed chairman said ”to date, the incoming data have supported the view that the current stance of policy is likely to foster sustainable economic growth and a gradual ebbing in core inflation”.

July 21, 2007 My guess is that if there is an interest rate change, a cut is more likely than an increase. The key variables to be watching at this point are real estate prices and the inventory of unsold homes.
August 11, 2007 I suspect that within 6 months the Federal Reserve will be forced to lower interest rates before housing becomes a black hole.
September 11, 2007 It only means that the overall process has flaws guaranteeing it will be slow in responding to changes in the economy... and tend to over-react as a result.
September 18, 2007 I think a 4% rate is really what is needed to turn the economy back on the right course. The rate may not get there, but more cuts will be needed with employment rates down and foreclosure rates up.
October 25, 2007 How long will it be before I will be able to write: "The Federal Reserve lowered its lending rate to 4% in response to the collapse of the U.S. housing market and massive numbers of foreclosures that threaten the banking and mortgage sectors."
"Should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses," he said.

"Uncertainties about the economic outlook are unusually high right now," he said. "These uncertainties require flexible and pragmatic policymaking -- nimble is the adjective I used a few weeks ago."

December 11, 2007 Somehow the Fed misses the obvious.
[Image from:]
December 13, 2007 [from The Christian Science Monitor]
"The odds of a recession are now above 50 percent," says Mark Zandi, chief economist at Moody's "We are right on the edge of a recession in part because of the Fed's reluctance to reduce interest rates more aggressively." [see my comments of September 11]
January 7, 2008 The real problem now is that consumers can't rescue the economy and manufacturing, which is already weakening, will continue to weaken. We've gutted the forces that could avoid a downturn. The question is not whether there will be a recession, but can it be dampened sufficiently so that it is very short.
January 11, 2008 This is death by a thousand cuts.
January 13, 2008 [N.Y. Times]
“The question is not whether we will have a recession, but how deep and prolonged it will be,” said David Rosenberg, the chief North American economist at Merrill Lynch. “Even if the Fed’s moves are going to work, it will not show up until the later part of 2008 or 2009.
January 17, 2008 A few days ago, Anna Schwartz, nonagenarian economist, implicated the Federal Reserve as the cause of the present lending crisis [from the Telegraph - UK]:
The high priestess of US monetarism - a revered figure at the Fed - says the central bank is itself the chief cause of the credit bubble, and now seems stunned as the consequences of its own actions engulf the financial system. "The new group at the Fed is not equal to the problem that faces it," she says, daring to utter a thought that fellow critics mostly utter sotto voce.
January 22, 2008 The cut has become infected and a limb is in danger. Ben Bernanke is panicking and the Fed has its emergency triage team cutting rates... this time by 3/4%. ...

What should the Federal Reserve do now? Step back... and don't be so anxious to raise rates at the first sign of economic improvement.
Individuals and businesses need stability in their financial cost structures so that they can plan effectively and keep their ships afloat. Wildly fluctuating rates... regardless of what the absolute levels are... create problems. Either too much spending or too much fear. It's just not that difficult to comprehend. Why has it been so difficult for the Fed?

About Me

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Michigan, United States
Air Force (SAC) captain 1968-72. Retired after 35 years of business and logistical planning, including running a small business. Two sons with advanced degrees; one with a business and pre-law degree. Beautiful wife who has put up with me for 4 decades. Education: B.A. (Sociology major; minors in philosopy, English literature, and German) M.S. Operations Management (like a mixture of an MBA with logistical planning)