As expected the Fed reduced by 25 basis points the funds rate to 4.25% and the discount rate to 4.75%. The stock market tumbled immediately after the announcement because there was hope that the discount rate would be cut by 50 basis points. Moreover, investors seemed to be concerned that the FOMC statement didn’t signal additional future rate cuts.
For example, Jim Cramer vented his disapproval saying, “a simple 25 basis points more would have made a tremendous difference for the economy’s psyche. It would have showed the Fed is on the case.” Although the Fed’s policy decision disappointed Cramer and the market, I believe many more rate cuts will be delivered next year – more than investors are expecting – though some would argue that it would be too late.
Currently, the futures market is pricing in a Fed funds rate of 3.25% by December 2008. I am willing to take the under on that bet. With eight FOMC meetings scheduled for 2008, I think it’s likely that we will see a two handle on the funds rate at some point next year. Let me explain.
I will concede the Fed is very concerned about inflation: they have expressed this whenever a microphone is put in front of one of its members. And it is why they didn’t deliver a 50 basis points cut yesterday. They are concerned because I am sure that they are not foolish enough to believe the CPI — after all, former Fed governor, Alan Greenspan, played a major role in its dubious construction.
But in the their view, high inflation is not necessarily problematic as long as long-term inflation expectations don’t rise. That is, if people don’t doubt the dollar’s purpose as a store of wealth, the Fed can print a lot of money and stimulate the economy. This makes managing inflation expectations critical, especially in the current environment of slowing economic growth where money printing would be useful. Thus, the rationale behind all the hawkish talk about inflation, while in practice they cut rates.
So although the Fed would rather not ease monetary policy, a weakening economy is forcing them to do just that. And the economic picture is going to get bleaker. Residential real estate, with high inventory levels and home affordability declining, will continue to suffer falling prices. This will exert a drag on consumer spending, which amounts to 70% of GDP, and therefore on the economy. Lower rates won’t lead to greater corporate spending either. Business investments have been sub-par even when the economy was strong, so it is unlikely to pick up in pace as the economy weakens.
In the last recession, the Fed had to reduce the funds rate to 1% to stimulate growth. That was a capital spending led recession. This recession is being led by real estate investment and consumer spending which are more meaningful to the economy. It would therefore be unlikely that a downturn can be overcome this time around with an easier monetary policy than implemented during the previous, more mild recession.
Now while I think the Fed will bring down rates more than consensus expectation, I am not suggesting this is the right thing to do. Actually, if I had my way the Federal Reserve would be abolished, but that’s a topic for another time. My belief is that an accommodative monetary policy is the wrong approach to dealing with the current economic problems — akin to giving more heroin to a heroin addict.
The money supply, as measured by M3, is growing at 16% annually: inflation is clearly a big threat to the economy, though its impact may take a while to be felt. The Fed, with the urging of Wall Street and Capitol Hill, will continue to lower rates which would help dealing with the near-term credit crunch, but will make the eventual day of reckoning more painful.
The US economy has a fundamental and serious structural problem: too much debt. That is, the greatest challenge the economy faces is servicing the existing debt, not access to additional debt. The cure for this is to let the market work by forcing bankruptcies and having the debt written off. A deflationary recession would ensue marked by declining corporate profits, job losses, and falling asset prices. Although this would be a harsh experience for most Americans, eventually the economy will be cleansed of distortions and it can get back to robust growth. Wouldn’t be nice to attain a 7-8% long-term growth rate rather than the 3-4% that we yearn for now?
However, the loose money stance the Fed has adopted actually makes the problem of excessive debt worse by encouraging more borrowing. Perhaps if the Fed prints enough money the debt will become worthless. In any case, the result will be that the economy should avert a severe deflationary recession in the short-run, but there won’t be smooth sailing either. As discussed before, home prices will be declining for a very long time, providing a substantial drag on consumer spending.
The excessive money creation stimulated by the Fed will rather spill into consumer prices, particularly food and energy. Thus, stagflation will be the likely result. Eventually inflation expectations will start to rise, and if Fed monetary policy isn’t altered, inflation will reach excessive levels — dare I call it hyper-inflation — and the whole monetary system will collapse leading to the deflationary depression that we are trying to avoid. I can’t put a timetable on this, but it’s a textbook pattern that has been played out frequently in history. I hope to expand on this point in a later blog post. So how does one protect oneself from all of this? My choice is gold.