How Low Can She Go - Do We Even Know?

KNZN mentioned that he didn't think real yields could collapse enough to produce a liquidity trap in an inflationary environment.

The 90 day T-Bill is now at half of a percent, and looks to be in freefall. Remember this is after the Fed annouced that I-Banks would have access to the discount window and that Bear Stearns was brougt back from the brink of bankruptcy.

Had Bear gone under could interest rates have remained above zero?

There is no tightrope. We should starting talking about making the financial sector an offer it cannot refuse. More on that tomorrow.

100 Basis Points

I am off to the state legislature this morning so no faux statement. However, I still maintain that there is no tightrope. The Fed has to be focused on preventing the liqudity trap and jump starting credit markets as soon as possible.

Moreover, M1 is flat and credit contracting. This should be leading to an effective decline in the money supply. Ultimately that is deflationary.

The statement should have some nod to commodity prices and risks but the predominate concern is stability in financial markets and the outlook for growth. In short, look out below, we are heading for 1% as fast as is prudent.

Note to Markets: Credit Will Be Saved - Equity Skewered

I am a big fan of what appears to have gone down in the Fed - JPMorgan - Bear Sterns deal. It worked out just about as well as it could given the situation.

Bear Stearns shareholders lost everything, which helps prevents moral hazard. Creditors, counterparties and clients were saved which keeps the financial system functioning.

When the dust settles this could be one central bankings finest moments.

Bang Up Job Guys

You really have got to hand it to the financial press. After stoking the fires of risk fueled housing and equity bull markets they have now fully transitioned into fanning the flames of widespread panic.

Its a wonder that more banks don't tap the discount window after the confidence inspiring conniption that virtually every financial pundit seemed to go through yesterday.

Was there a major crisis at Bear, of course. By no means am I suggesting anything less. However, the term "FED Bailout!!!" was splashed across every TV and computer screen that I saw, when the reality was somewhat more prosaic.

About three-quarters of the way down this Wall Street Journal article the author admits that

technically the Fed still hasn't lent directly to investment
bank

because

the New York Federal Reserve Bank had agreed that it would provide financing to Bear Stearns via J.P. Morgan Chase. J.P. Morgan Chase was used as a conduit because, as a commercial bank, it already has access to the Fed's discount window

So basically, as I see it, the Fed encouraged JP Morgan to use the discount window essentially as intended - to stem a bank run.

Now, it wasn't a bank that was being run but in our modern financial system the Fed understands that intermediation extends far beyond traditional banking institutions. Yet, the Fed still went through a member bank to conduct this operation so as to avoid mudding the waters as much as possible.

As far as I can tell the big innovation was that Fed guaranteed Morgan against losses, which given the time frame available seems not only prudent but reasonable.

Liquidity Trap, Delfation, ZLB

Lots of people have said to me both on and off line that we don't have to worry about the Japan Scenario because we have a solid inflation buffer in the US.

While the inflation buffer gives us more room in a sense, it is important to remember that it is not deflation per se that causes a liquidity trap. It is that the equilibrium interest rate is below zero.

It is possible that the equilibrium risk free interest rate is a real negative 3% in this crisis, which implies that we still won't be able to get there with 2.7% inflation.

Exploding risk premiums could drive the equilibrium real rate that low because what matters is credit availability to firms and consumers.

So we are not in a position were we can ignore the liquidity trap possibility. On top of that is the issue that there are increasing deflation pressures in the decline collateral values, falling consumption and the potential for dramatically slower global growth. While ultimately they might not override inflationary effects of recent Fed policy, they are not to be ignored.

In short deflation cannot be ruled out and the liquidity trap remains a threat even in a moderately inflationary environment.

Immaculate Inflation

Some of my fellow bloggers have been looking at inflation expectations and are worried that the Fed is pumping too much cash.

I am skeptical.

Inflation ultimately has to come through the interaction of supply and demand. Money creation may be the source of surging demand and hence higher prices but demand has to in fact surge. It is difficult to have Fed driven inflation in an environment of falling retail sales.

If consumers contract then businesses loose pricing power. Commodities ultimately have to follow business demand.

Mo' Better

I may be one of the few bloggers who think the Feds policy actions are now moving in exactly the right direction. My long standing view is that we are experiencing the popping of a massive credit bubble that extends far beyond subprime mortgages.

A credit bubble happens when the price of credit becomes to low rather than too high. Low priced credit like asset bubbles can be self-reinforcing. Cheap credit means that people can easily refinance their old debts. This puts more money back into the market at lower risk levels which further encourages cheap credit.

See, essentially the price of credit is determined by two things. First, is the scarcity of money. When you loan someone money, you can't use it to buy things yourself. Therefore, few people want to loan out all of the money they have. However, if the government prints more money, more can be loaned out without running short.

Controlling the quantity and hence the scarcity of money is usually what the Fed does to control the price of credit.


However, there is another factor, default risk. Even if you didn't need your money right now you might be hesitant to loan it out if you thought you wouldn't get it back. Hence, the price of credit rises when people think they might not be repaid. The difference between the price of risk free loans and risky loans is the credit spread.


So, how does this affect the current situation. The subprime explosion and subsequent implosion happened because of collapsing credit spreads. That is, investors stopped worrying as much about getting their money back. In particular they believed they had fancy computer simulations which assured that they could make money even if lots of the loans defaulted. As long many of them did not, it wouldn't be a problem.


Now it turns out that those simulations were based on a world in which credit was relatively hard to come by. This new world, in which investors were loaning to anyone with a pulse operated by different rules. In short, the computer simulations lead to the creation of a world in which the simulation was no longer valid.

Computers in some ways are like extreme autistics who often suffer from these types of recursive mistakes. They fail to realize that the response pattern of the outside world is dependent on the outside world's perception of the computer's response pattern. Thus an infinite cycle of you think, that I think, that you think, . . . is set up. Cognitively normal people can solve these problems intuitively but they form a serious calculation issue for computers and autistics. But, I digress.

The important thing is that the simulations failed to account for the changing nature of the credit market. Thus, investors took on way more risk than their analysis had predicted. In late 2006 and early 2007 it started to become clear that the analysis was wrong. By the summer of 2007 credit spreads were spiking as investors tried to undo what they had done.


The Fed, at first tried to fix the problem by increasing the supply of money. The hope was that this could drive down the price of credit, allow people to refinance and investors to get out of the bad deals they were in. However, the deals were going bad too fast. The Fed could not keep up and despite their best efforts spreads are growing again.

So what do?

The Fed must attack the credit spreads not just the scarcity of money. This is what it is doing now by taking an increasing variety of assets as collateral for up to $200 Billion in loans. What that means is that the Fed is allowing banks to borrow cold hard cash by using your risky asset as collateral. In addition, its going to keep rolling this loan over indefinitely.

This means that some of the risk has shifted from the bank to the Fed. If the asset goes bad and the bank can't repay its loan to the Fed, the Fed ends up with the bad asset. In a sense it implies that risky assets are only so risky because at the end of the day you can always pawn them off on the Fed.

Doesn't this put the Fed at risk? Well, the Fed buys the asset with money that it creates out of thin air. Things get a little complicated when one considers that the Fed has to also keep an eye on the Federal Funds rate, which it manages by creating money out of thin air. Yet, I don't think thats much of a problem. This post is already longer than I intended so why its not a problem will have to be saved for another day.

There is No Tightrope

The analogy of Ben Bernanke walking a tightrope between a recession and inflation has become popular of late. However, I suspect that the Federal Reserve increasingly is coming to believe, as I do, that there is no tightrope.

Inflation is here, yes. Commodity prices in general and agricultural prices are skyrocketing. This is something that we talked about here last year. However, the Japanese Scenario is becoming more salient everyday.

As I say regularly to my colleagues, "This is not just sub-prime, this is not just housing. This will get much worse before it gets better"

I am sorry that I do not have the time to post lots of interesting graphs as evidence. What I am worried about, however, is a recession within a recession and the consquences for solvency in the financial sector.

So far there have been some very high losses associated mostly with subprime mortgages. However, this is potentially the tip of the iceberg. Much larger losses will could come from the set of mortgages known as Alt-A, along with consumer credit, commercial real estate loans and corporate loans.

Now, unlike subprime many of these loans will not experience high default rates in the absence of macro events such as declining home prices or rising unemployment. Therefore, those losses are starting to trickle in now. Alt-A today for example is probably at the same point in the rising default cycle as subprime in late 2006.

We see that home prices are falling but what about unemployment. If we look at the business cycle spikes in unemployment are typically led by a slowdown in residential construction and are accompanied by a drop in business investment spending. In fact by the time unemployment spikes residential construction is typically on its way back up.

This time may be different. Business investment is already slowing and unemployment rising. Yet, there is reason to believe that residential construction could fall throughout the rest of the year.

In a sense this means that we will be in the midst of a recession (high unemployment), at the same time that we are experiencing leading indications of a recession (construction slowdown). This sets up the possibility for a vicious cycle in which unemployment further depresses housing which leads to even greater unemployment, or a recession within a recession.

This scenario must be avoided. The Fed should acknowledge that inflation is a problem but should begin to brace the nation for a policy designed to beat back a Japanese style depression without regard for the immediate implications for inflation.

It Only Seems That Way

"Why would you ever want to take on more debt than your home is worth," ask Mike.


The short answer is that when you think liquidity is going to be a problem it is always better to have money in the bank and higher debt than no money in the bank and lower debt.

A longer answer is that people often think of taking out loans so that you can buy something you want. Ultimately, this is what most people do with borrowed money. However, you can also take out loans just to have more cash in the bank.

This is what I suggested that homeowners do. You never know when you will have an emergency, loose your job, etc. If you have credit available then you can whether those situations. If not, then you may be forced into dire straits such as foreclosure.

Therefore, if you think your credit is about to dry up, its always in your interest to pull out the money now. You can put it into a high yield savings account. If you never use it then you only owe the difference between the interest you are paying and the interest you are getting.

If you do use it then it could save you.

Now, thats the responsible take. Their is a less responsible corollary. That is, if you are planning to spend way beyond your means then you might as well borrow that money at 8% from your home equity line of credit, rather than 23% from your credit card.

In either case, it is better to borrow cheap easy money then be stuck borrowing expensive money or being short of money.

Of course, it would be better still to save responsibly and be lucky enough not to have an emergency. However, many people who have decided to live beyond their means are not going to stop until they are insolvent and almost by definition its difficult to control emergencies.

I don't know if that helps, but its important not to confuse borrowing with spending. Borrowing is a lot of money is imprudent. Spending a lot of money is imprudent.

Last Straw for the Consumer

A while back I suggested that smart homeowners were loading up their HELOCs before the door was shut. Turns out the door is being shut on Monday. Calculted Risk reports that both Chase and Countrywide are placing new limits on how much consumers can borrow.

Without access to Mortgage Equity can the consumer continue. Moreover, consider the on going possibility that high US consumption is being driven by a minority of consumers who have been drawing on heavily on home equity. With the door shut on those high spending consumers we could see a dramatic realignment in the US savings rate and with that a global recession.

50 Bps ???????

I am at a loss for the move today. On the one hand I think the Fed can safely cut 50 without spooking the markets. There is a hope at least that swift cutting now can avoid us having to go all the way to zero if the recession gets out of hand. Remember that we went to 1% last time and we started from a higher funds rate.

On the other hand the SocGen incident has to be a little embarrassing personally for the FOMC. There is certainly the sense that they may have been jumping at shadows. This argues for 25 bps if any.

At the end of the day, however, avoiding the Japan type scenario has got to be the priority. And, with slowing global growth inflation concerns may be moderating so. 50 bps and say something like:


The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 3 percent.

In recent months the outlook for growth has weakened. Credit markets have remained strained and the slowdown in housing has continued to diminish output growth. Some businesses and households are finding it more difficult to obtain credit.

Commodity prices have moderated in recent weeks and inflation pressure appear to be weakening. Nonetheless, the committee will monitor incoming data for signs of increases in inflation expectations.

Some downside risks to growth remain. The committee is monitoring incoming data as it becomes available and is prepared to act in a timely manner to address those risks.


Notes:
Acknowledgment that oil prices are retreating. Direct references to financial institutions removed. Appreciable downside risk becomes some downside risk.

Did The Fed Cater to Wall Street

Do I think anyone on the Federal Open Market Committee said "Look these losses in the stock market are unacceptable we need to move" - no I don't.

Was there concern that widespread panic was ensuing that would result in a capital market freezing up - likely. Moreover, it was a sign that market participants were significantly increasing the likelihood of a major financial institution failing, this concerns the Fed deeply.

Look, I was shocked at the move and I am not certain that it was the right thing. Only hindsight can tell. However, we had started to get conclusive data that the US was slipping into recession. Because credit quality is already slipping a US recession is likely to be self-reinforcing.

That is, high unemployment leads to more foreclosures which leads to less lending which leads to higher unemployment.

So there was definitely a need to act. Last week I was even open to 75bps at the Jan 30 meeting. My biggest concern was spooking the market. But, the market was already spooked, so no loss there. So I believe the cut was designed to stem the recession. The collapse in equity markets was a sign that the recession was worsening and could itself contribute to the recession if it resulted in less spending or lending.

However, that being said the members of the FOMC are human. It was hard to watch the entire world selling off and not do something. I mean you could see that markets tumble literally as the world turned. As soon as daylight hit a region, it was in the red.


As for the ECB's tough talk. Number one, they do not have a dual mandate. Technically, they are responsible only for managing inflation not unemployment. However, I also think they are somewhat in denial. We have seen this before. We saw Japanese central bankers in the early 90s in denial about how bad it could get.

What we are looking at are severe downside risks and now it the best time to stop them. If a Japan type scenario is on deck for the US, this would be the time to prevent it. So while the move shocked me, I understand it.

I am sure Bernanke does not want to leave his post wondering if he stood by while the same forces that engulfed Japan, take down the US. If that means that he has to risk his rep now, I am guessing he says, so be it.

Rate Cuts and You

Mike asks how the rate cuts will help the common man. In some ways this question cuts to the heart of monetary theory and policy. In principle the sole purpose of monetary policy should be to help the common man. Is that whats going on now.

Yes, and no. Its very very tempting for the monetary authority to focus heavily on assets prices and as such the upper class. You get instant feedback about expectations, liquidity, and overall wealth by looking a equity and credit markets.

To find out whats happening to the Joe on the street takes years and even then we are often not sure if we have the right metrics. Moreover, Wall Street is often clamoring for help while the Joe Sixpack may not even know what the Fed is.

However, cuts (and hikes) do wind up having their biggest effect on the weakest members of society.

Why?

Because, those members are the most vulnerable to inflation and unemployment. When the Fed cuts now the hope is threefold.

1) This will lead to more favorable mortgage and credit card rates which will relieve the payment stress on average consumers

2) That if consumers can slowly, rather than dramatically reduce spending growth (as they must) then businesses can adjust without resorting to mass layoffs.

3) That we can ease pressure on the banking system so that more people and businesses will be able to get credit when they need it.

All of these things should ease the stress on the common man. The reason I did not believe we would have cuts this morning and some economists are upset about them is because it looked as if the Fed was going to far to stem losses in financial markets.

This is a really hard call because losses in financial markets can lead to pains for the average worker if it means that corporations have a hard time raising capital and need to instead turn to layoffs.

At the same time, however, more vulnerable Americans who have relatively fixed incomes are susceptible to inflation and there is some evidence that inflation causes the entire system to be sluggish. Not to mention the problem of encouraging financial speculators to take risks if they believe the Fed will bail them out.

So, the upshot is that the cuts should reduce some stresses on average people and hopefully reduce painful layoffs.

Bernanke needs to Speak Tomorrow Before the Open

if this continues . . .

The key word is promptly. The Fed is prepared to act promptly to signs of further deterioration in output and employment.

Further the Fed is prepared to act to support the smooth provision of credit and stability in financial markets consistent with the dual mandate.

50 now and hints at Intermeeting Cut

I'll put up a more definitive rate preference and statement later, but right now I lean towards:

1) Cutting 50 bps on the 30th

2) Saying something like "The Committee is monitoring the data closely and is prepared to act promptly to increasing signs of deterioration in growth and employment"

A growing risk is now generalized, rather than simply asset, deflation. It is quite a difficult time for central bankers, when both inflation and deflation are credible risks.

This makes language crucial in communicating to the markets. In particular, participants need to know what the key data measures are so they can update their expectations. In particular I would point the markets towards unemployment and agricultural prices. Although these may not be leading indicators they are quite solid indicators of where the pressures are and we can feel more confident in taking large actions based upon them.

In particular if Ag prices fall I don't see how general inflation holds up in this environment. Not that Ag prices are pushing general inflation but they indicate a worldwide slowdown in demand growth.

Dark Matter in Action

The Economist is concerned about Sovereign Wealth Funds and it appears Washington is as well. My personal reaction when I heard that international investors were pouring another 12.5 Billion into Citi on top of the 7.5 Billion they received at the end of last year was a bit different. This, I thought, is Dark Matter in action.

Dark Matter was a much ballyhooed hypothesis that the US could manage to run such large trade deficits because it was making a killing on its investments overseas. Think of it this way. Suppose you borrowed $100,000 at 5% interest. You took half of that money, $50,000, and blew it on a big screen TV, new stereo, trip to Thailand etc. You took the other $50,000 and invested it at 15% guaranteed.

So you end up having to pay $5,000 a year in interest, but you are receiving $7,500 in interest. On net are in debt? What does it mean to be a net debtor if you are actually taking in more money on your investments than you are paying out.

Yet, someone who looked at your spending habits would say, "you borrowed $50K and blew on junk, you must be in debt."

In a nutshell is the situation the US finds itself in. Went spent a bunch of borrowed money on junk but we managed to invest the rest at incredible rates - or so it seemed.

A more careful examination of the data revealed that it wasn't that the US was earning amazing returns on its investments. It was that foreigners were getting a lousy return on the money they loaned to us or otherwise invested in the US.

Which brings us back to Citi. Are foreigners swooping in to buy one of the US's venerable institutions at fire sale prices, or like the Mitsubishi purchase of Rockefeller Center, are they overpaying for a famous property that can no longer produce. My guess is that it is more the latter than the former.

On Going Issues

1) On Thursday Bernanke started to use the kind of language that I was hoping he would use. Hints that the FED would be highly responsive to further deterioration. Thats the kind of assurance that helps smooth the non-linear waters of the market. Sometimes, a big move or the potential for a big move can have a stronger effect than several smaller moves of equal total magnitude.

2) We'll get retail sales tomorrow. Thats the last piece of the January data set I expected to justify strong action. If retail sales is as ominous as I suspect we should start talking about 50 bps with a strong bias towards cutting.

I am also not completely and totally immune to arguments that push 75bps. Though I would have substantial hesitation on many fronts including the risk of spooking the market. I don't think we have seen a cut above 50 bps since the early 1980s.

3) I have mixed feelings about the increasing realization that subprime was just the canary in the mine shaft. Alt-A mortgages, credit cards and CDS on corporate issues are next. There is some sense vindication in that this is turning out not to be a housing bubble but a credit bubble all around. However, of course it would have been better to be wrong.

What Bank of America Was Thinking

I was on the inside of Bank of America for a while as a consultant. I signed a deal that said I wouldn't talk about anything I overheard for three years but it has been much longer than that and I am sure that my thoughts are generally old news. Nonetheless I think they are worth sharing.

Bank of America was heavily investing in Consumer Real Estate, thats what they call mortgages, when the subprime boom hit. The goal at The Bank, was to streamline the entire haphazard process of mortgage application and underwriting. In particular they wanted a single computer system that could automate the entire process. In the past there had be a hodge podge of different systems and departments that did everything from taking applications, to verifying income and assets, to making sure the house wasn't in a flood zone.

The idea here, and behind a lot what The Bank, was doing was that consumer banking was about information. Their real asset was that the mortgage application let them stick their noses in all of your nitty gritty financial information, which they could then use to sell you every product under the sun.

In particular a few key executives were really into this notion that The Bank could be a conduit for every imaginable service related to a home. Bank of America could arrange your lawn service, your pool service, your home security service, everything you wanted. And since, they knew so much about you they could figure out exactly what you wanted.

It was the fees on these service that were going to be real winners. So, what is The Bank getting when they buy Countrywide? They are getting the largest mortgage servicer in the country and access to lots of homeowners whom they plan to sell lots of other stuff to as well.

My concern, however, is this - Bank of America looks so responsible because they didn't really dip into the subprime waters like other banks. My feeling, however, is that this is because they already had a big project going when subprime came along and they didn't want to muddy the waters with this new poorly understood stuff.

However, The Bank is heavily into credit cards, which are going to be the next take a hit. The Bank also is taking on a lot of servicing responsibility with Countrywide. To the extent that
not just subprime but Alt-A and even adjustable rate prime mortgages start to go delinquent, The Bank is going to be responsible for advancing interest payments to the investors in those loans. That is a heck of a liquidity responsibility. I would like to hear more about how The Bank would fare if prime ARM delinquency rose substantially.

What Happened in New Hampshire

There is a lot talk about what turned the tide for Hillary; the cry, the contrarian nature of New Hampshire, Chris Matthews, the debate.

Yet, in my mind I cant help but wonder how many women in Iowa were afraid to tell their husbands and boyfreinds that they supported Hillary. Caucus is out in public and subject to public pressures. Women may have decided to keep the peace rather than echo their support.

The when the pollster called New Hampshire the next day the state was swept up in Obama fever. By Tuesday, however, when women were all in alone in the voting booth and had to decide whether they were going to kill the hope of Hillary being president or let her live for the day, they went with their gut.

Will The Recession Be Outsourced?

So, US consumption growth will decline - that much is clear. Indeed, in the short term consumption is likely to contract in real terms.

The quandary now is how much of that reduction in consumption will raise unemployment in the US. Traditionally, declines in consumption translate into declines in manufacturing employment. Yet, these days a smaller and smaller fraction of the US population is employed in manufacturing.

Can manufacturing still cause a recession when it employs only 10% of the workforce? Will the declines in employment cut deeply into the traditionally stable service sector? Or will the recession be outsourced? That is, will the decline in manufacturing jobs that typically accompanies a US recession really hit manufacturing employment in other countries.

My intuitive take is that the service sector will take an unprecedented hit but that much of the increase in unemployment will be exported. My pet theory is that we are moving into a strange world of recessions without large increases in unemployment.

The pain of the recession will be felt in asset declines, and workforce relocation. Workers will slide into lower paying less productive jobs but not on to the unemployment rolls. These working recessions will see declines in productivity and an evisceration of corporate profits.

But thats just a pet theory. Time will tell.