Saturday, November 17, 2007

Bringing balance to the Force

I think the media is misunderstanding Fed Governor Randall Kroszner. His speech delivered yesterday at the Conference on Competitive Markets and Effective Regulation has been interpreted as favoring no more cuts. The money quote:

"A sequence of data releases consistent with the rough patch for economic activity that I expect in coming months would not, by themselves, suggest to me that the current stance of monetary policy is inappropriate."

I know most people, even most pros, don't actually read the speech and instead just read the story on Bloomberg or the Wall Street Journal. But if you bother to actually read the whole speech, there is much more time spent on the weaker growth picture. Consider this reality: the Fed has cut 75bps, which is historically an extremely tepid easing cycle. Furthermore, the current environment has a larger tail risk than some past down cycles.

There is some non-zero probability that subprime losses will take down one or more large banks. I don't think the odds are high, but the possibility exists. What if this causes a crisis of confidence in our banking system? Furthermore, its possible, however likely, that banks will tighten consumer lending practices to the point that consumer spending plummets. Or that losses in consumer lending lead to extremely tight business lending.

Kroszner himself discusses the outlook along these lines, mentioning "median" and "tail" outcome possibilities. While the media has focused on the quote above, I think his thoughts on reducing tail risk is the key to what the Fed is likely to do next.

So the Fed claims risks are balanced. And maybe this is technically true, in that the median forecasts might suggest that rising inflation and falling growth are both about as likely. But the tail outcome for growth is too disastrous to ignore. And the Fed knows they have the tools to let banks earn their way through this period through carry.

Look for more cuts. Several more.


Anonymous said...

Seems cogent to posit that the only way out of this mess is to cut rates to keep the spending on a roll.

I'm confused by the seemingly circular reasoning that banks don't know what they are worth due to the "mark to mystery" dilemma,yet we can "know" that lower rates will save them by "carry". Wasn't a form of "carry" the egg that gave birth to the chicken, or vice versa. Or will the bankers be smarter this time.

Anonymous said...

Well, don't you have to bring the dollar into this?

Fine. Lower rates. The constituency for lower rates includes the Federal government and the consumer. Pretty large constituency.

But a dollar that continues to tank presents some difficulties.

I think the biggest is that significant portions of equity get bought by the Chinese. Maybe that bank that is going to fail.

Somehow, I think the Chinese are going to insist on some value for their dollar.

Anonymous said...

I don't doubt that the Fed can save the banks by driving interest rates down as low as they need to go -- but as Japan illustrates, that's no way to save the economy.

The job of a lender of last resort is not to bail out the banking system when it gets into trouble, but to throw just enough money at the banking system when some banks collapse to keep the collapse from taking down fundamentally sound banks. A properly run lender of last resort makes sure that any bank that is so badly managed that it is triggering systemic concerns is turned over to new management within a short time frame.

In short, if Fed feels obliged to cut rates to support the banking system and we don't see some bank failures, the Fed is definitely not doing its job.

Anonymous said...

You'll have to explain to me how there is carry in the traditional sense ...
When Mr. G bailed out the banks it was a simple exercise...under his edict Two year notes became a risk free trade in infinite size as long as he guaranteed the terminal rate on FED FUNDs...

What assets is "risk free" now to carry?

Anonymous said...

They're steepening the yield curve to bail out the banks at the expense of everyone else. Low rates at the short end will put the dollar into freefall and spread global inflation contagion; high rates at the long end offer no relief for mortgages. In the end, you'll get the worst of all worlds: stagflation, foreclosures a-gogo, and Citigroup will need rescuing anyway, only this time the white knight from overseas will be Chinese instead of Arab.

Anonymous said...

What if this causes a crisis of confidence in our banking system?

What if......We're there....Banks need a bailout... and maybe Fannie too.... Any thoughts on FNM's credit loss ratio? YIKES!

Anonymous said...

AI: Bernanke said he was adding food and oil to the inflation measure. What will be the source for his data manipulations to justify a cut once he includes consumable and oil inflation?

Anonymous said...

And we know from '03 that they pay attention to tails.

Accrued Interest said...

I think too many people are too worried about the dollar, which I have written about several times. The evidence that a weak dollar causes inflation is poor.

Banks don't need risk-free assets, just performing assets. And they have plenty of performing assets. I think we're getting closer and closer to reality at most banks/brokers about their subprime securities losses. Citi may turn out to be a notable exception.

I think the inflation cost of getting through this will be modest as far as the Fed is concerned. But problematic for investors in long-term Treasuries, which I believe will rise in rate from here.

The comment on '03 is exactly on point.

And finally, remember, bear should be a market view, not a state of mind.

Anonymous said...

Last month I was at RiskUSA where the Fed's Mishkin gave the keynote. The press' report of his speech was very different from what I heard.