This is the best perspective on the Feds decision I have seen. I agree wholeheartedly with this assessment. Chairman Bernanke has been put in a difficult spot because of Greenspan's mistakes, but in my opinion he swung and missed on this. His decision (in my opinion at least) was a major blunder.
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They Actually Did It – Cut Rates That Is
Well, they actually did it. The Federal Reserve, and
Chairman Bernanke, cut the federal funds rate and the
discount rate by 50 bps. The Fed argued that their action
was meant to “help forestall some of the adverse effects
[from tightening credit conditions] on the broader economy.”
The stock market loved it with the Dow up more than 400
points over two days, and the NASDAQ up more than 80
points. The pundits loved it, too. But cash gold prices have
now moved above $730/oz. If prices stay at this level for a
month, gold will set a new monthly all-time record high.
Oil prices jumped to an all-time high, of $82/bbl., and the
dollar tanked, losing more than 1% of its value versus
foreign currencies. To top it off, the price of the 30-year
Treasury bond has fallen by more than three full points,
pushing the yield to 4.92%, which raises the cost of fixed
rate mortgages.
The rise in stocks was probably welcome by the Fed, but we
can’t imagine the Fed wanted to see inflation sensitive
markets behave this way. The Fed’s number one
responsibility is to protect the purchasing power of the
dollar. But this is not happening.
A Misunderstanding of the Problem
Some analysts thought a Fed rate cut would push the dollar
up and gold down. They argued the Fed was so tight that
markets were being squeezed, and this was causing demand
for the dollar to fall. They also argued that if the Fed cut
rates, and supplied new money, the markets would unlock,
demand for the dollar would rise, gold prices would fall and
the dollar would rise. Oops!
The idea that the Fed is too tight is based on a few different
arguments. First, that trouble in commercial paper markets
does not occur unless liquidity is scarce. Second that
housing is a leading indicator of Fed tightness. And finally,
that real GDP grew just 2% in the past year.
But none of this is proof of tight money. Every single
problem in the economy and credit markets emanates from
housing. And the housing market is clearly suffering
because interest rates were too low between 2001 and 2004,
which led to absurdly loose credit standards. So loose, that
even Alan Greenspan could not imagine how much lending
standards had deteriorated. In some ways we can’t blame
him. Who could imagine mortgages were being made to
people with no money down and no proof of income? And
who could imagine those loans were bought by the smartest
people in the room at major hedge funds?
But they did. And the reason this house of cards is falling
down is because interest rates did not stay absurdly low. But
that does not mean interest rates are too high or that the Fed
is too tight. In fact, interest rates today are significantly
below the levels of the late 1990s when things were so good
it was called a bubble – a false boom. Today’s problems
exist because interest rates were too low, not because they
are too high.
It is the excesses of the past that are causing problems in the
asset backed commercial paper market, not tight money, and
ditto for the housing market. In addition, non-housing real
GDP grew at a 3.1% annual rate in the first half of the year.
No evidence of tight money there.
Pushing on a String
To understand why the Fed’s policy stance is inflationary, it
is important to understand monetary policy. And the first
thing to understand is that the Fed does not control interest
rates directly. It controls the money supply. By injecting
more money in the system, the Fed drives interest rates
lower. If the Fed withdraws money, or slows its growth, it
pushes interest rates up.
Despite this truth, most people mistakenly view Fed policy
through the lens of interest rates and believe lower interest
rates are a catalyst for increased economic activity and
greater profits. But this is only a short-term phenomenon. If
the Fed is holding interest rates below their “neutral rate,” it
must inject more money than the economy actually needs.
This creates inflation.
That’s what commodity prices (including gold and oil) and
the weakening dollar, are telling us – the Fed is adding more
liquidity than the economy really needs. This is the danger
of trying to fight off credit market problems with easy
money. Lower interest rates can make things appear
profitable when they are not. Eventually, the piper must be
paid and that will come in the form of losses to investors and
higher interest rates in the future.
The End Game
The Fed is most likely aware of all these risks and took them
willingly because it is involved in a risk management
project. The Fed believes risks to the economy are greater
than the risks from inflation. It also believes any extra
inflation that results from Tuesday’s rate cuts can be offset at
some future date.
The problem with this thinking is that the Fed cut rates
before inflationary pressures had actually receded. When
Alan Greenspan cut rates (and the Greenspan Put was born)
dis-inflation was the story. This meant that the Fed could
risk easy money for a while without creating a situation it
could not control.
This time, inflation is still in an upward trend. Moreover,
this is the lowest real federal funds in over 40 years at which
the Fed reversed course and started cutting interest rates (see
chart). In other words, the Fed cut rates this time before it
ever got tight, unlike 2000 or 1989.
In its statement describing why it moved, the Fed tipped its
hat toward these risks, acknowledging “some inflation risks
remain.” But obviously it was willing to ignore this risk for
the time being because it foresees problems with the
economy that are not visible with the naked eye.
The Fed cut rates with the stock market still up on the year,
real GDP growth averaging around 3.5% between March
and September, very low initial unemployment claims, and
some clear improvement in commercial paper markets.
If the Fed can cut interest rates in this environment, when it
still sees risks of inflation, then no one can argue that it
won’t cut again. As a result, even though the economy and
equities markets will respond positively to the easy money in
the next six to nine months, inflation risks will remain.
That said, further rate cuts are unlikely if economic activity
remains robust. And that appears highly probable. The
housing market is only 5% of the economy, liquidity is
plentiful and free capital markets are perfectly able to absorb
losses. As a result, it is highly likely that in 2008 the Fed
will be forced to reverse its rate cut and push rates above
5.25%. At that point, just like after the rate cuts in 1987 and
1998, the economy will face its greatest risks.
