Category — Deflation and Inflation

As predicted, the Federal Reserve Open Market Committee (FOMC) dropped its core interest rate by 75bp. A surprise to many, not to this blog. Enough bragging, these are scary times:

• The first reason is the FOMC statement: “The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent”

A target range? This is the first time in recent memory the FOMC has stated it would establish a range and not a specific rate for its open market operations.  The minutes of this meeting will be very interesting:

• This blog will predict that the FOMC will admit it has lost control of the Fed Funds rate.

And that is very scary. Even though the Fed now pays interest on reserves, instead of only buying short term treasuries -, the actions to control the Fed Funds rate are not working: There is no demand to use capital in this economy: From the Financial Times:

• The Fed Fund rate sits at 0.12%, remaining unchanged from before the rate cut.
• Overnight LIBOR is 0.0115% (because the Fed pays interest on reserves)
• Overnight 3m Treasuries are 0.01%

Deflation:

Reserves sitting at the Fed have ballooned to almost $700 billion, comparable to envisioned TARP program.  Yet that money is parked there most likely because the Fed has been gobbling up Treasuries, driving the yields to zero. It is not going outward into the economy.

If you believe in Milton Friedman, then you believe the following:  Without lending activity and expansion of the monetary base - demonstrated by these spreads - then at best, the money supply is not keeping pace with the economy. Therefore, deflation.

It might be worse. If the expansion only sits in existing treasuries, and those treasuries are not new issues for new government programs - aka - the stimulus, then all we’ve done is increased the demand for treasuries and done nothing to expand the economy. Further, remember the taxpayer has only saved money from the latest treasury issuance. Other issues had more expensive yields. In a deflationary environment, this problem is only compounded. 

Until the stimulus is enacted, we must expect a deflationary environment for at least the short term. And that will cause the FOMC to continue its inabilty to control the Fed Funds rate.

The Fed Open Market Committee recently announced the extension of its December policy meeting from one to two days. With extra time, I argue the Fed should strongly consider cutting the target Federal Funds rate from 100 basis points (where it currently stands) to 25 basis points.

• As I predicted in Note Twelve, overnight LIBOR has converged upward, reaching the target Federal Funds rate of 1.00%. This is because the Federal Reserve now pays interest on all “excess reserves” banks now park at the Fed.
• A look at TIPS vs. Treasury Yields over the next year still shows wild expectations of deflation. Ergo, even though banks’ excess reserves receive a measly 1.00% by doing nothing, they make larger returns in this environment.
• Though the Fed is paying the target rate for excess reserves, the effective Federal Funds rate still trades at 59 basis points, according to the Financial Times. This is because our Government Sponsored Entities can not receive interest from the Fed on their parked capital. With no bank wanting to use their funds, the Federal Funds effective rate declines further from the target rate.

Most “Fed Watchers” expect a 50 basis point cut in December. As you can see, we are already there. A further cut of this magnitude are moot.

A semi-coordinated solution:

Between the Fed’s recent program and the Treasury’s TARP program, we are going to “borrow and spend” (or print and spend) a further 10% of GDP on “unclogging the system”.

• The TARP program should be injecting enough preferred equity capital to improve bank balance sheets. Yet lending has not picked up, as I argued in Note Twelve.
• I believe the new Fed program should help eventually reduce excess Government Sponsored Entity capital sitting at the Fed by buying mortgage backed securities guarantied by Fannie and Freddie. But it is too soon to tell.

Therefore, the FOMC needs to triangulate a strong signal, telling the banks what all pundits, bloggers, and congressional representatives have been saying for some time:

“Get your capital out of my bank and start lending!”

At 50 basis points, I have argued we would see no change from the current situation. Cutting the Federal Funds rate to 25 basis points should hopefully force a change in bank behavior. Fed rates would just be too low, even with deflation expectations, for opportunities not to be exciting. With it should force excess reserves out of the Fed and back into the the market at essentially risk-less rates.

Cut the rate to 25 basis points and Happy Holidays!

On November 3rd, I wrote that the market was already stating deflation in the US was on its way. TIP yields were priced way above treasury yields, even correcting for recent large capital flight into the US.

Today, the market reacted to the  price declines in the UK and the US for the month of October:

• For the US, prices declined by 1% for the month of October
• For the UK, October hosted the steepest drop in prices since 1997

Lesson one: even in illiquid times, its hard to bet against the market.

Here are a few reasons why it is not surprising to see price declines of this magnitude in either country.

• I would argue most importantly, both countries have witnessed massive home value declines. Essentially, every family in each country was forced to estimate their now reduced net worth (with great uncertainty) and reign in spending on everything from cars to consumer durables.

• Oil, which both countries import, has declined almost $100 a barrel in the last few months. The fact that oil has declined has two profound effects:

1. While the FED dismissed energy as part of core inflation, increases in energy increase the cost of goods produced and sold (including food), increasing prices throughout the economy. In turn, a decline in energy should result in a decline in all prices.
2. Increases in import prices put stress on the balance of accounts, forcing currency devaluation, which in turn increase prices in the short term. Therefore, a decline in imports (as oil has declined) should improve the current account balance, improve currency (as the dollar has strengthened) and reduce prices.

However, now the UK and the US are in two different positions.

• The UK has a base rate of 3%

• The US has a base rate of 1%

The UK therefore has greater room to maneuver. The US has all but exhausted its monetary toolkit to fight deflation and grow our economy. All but certain, the Fed will slash rates by 50 basis points this December, and perhaps provide guidance it will not increase rates anytime soon.  When Obama assumes office, the new administration can only (and must) invoke a massive fiscal stimulus to revive the economy, hopefully in the form of infrastructure spending and tax cuts.  Across the pond, The UK still has the ability to do both to fight deflation and revive its economy. Further, a decline in rates for the UK should further reduce the Pound, allowing the UK to help export its way out of this malaise. The US does not have this luxury.

While many in the US are against government spending, I hope they realize that as of now, we do not have a choice.

Reporter Saskia Scholtes of the Financial Times was wise to diagnose our current crisis correctly almost one year ago on Newshour with Jim Lehrer. We had a “financial markets problem” We still do.

Since Ms. Scholtes’ diagnosis, it is becoming clearer the “financial markets problem” is spreading to the overall economy. This is particularly worrisome over this past week with special attention the Fed’s policy decision.

As we correctly noted in our previous post (to be sure, this blog is large enough for our over sized ego),

Ben Bernanke and the Federal Reserve enacted a massive rate cut. But has it worked? Has it bolstered confidence in the overall markets? We present two frameworks to analyze the cut and the market’s reaction (assuming additional pricing was occurred).

First is oil. Oil’s trajectory in various days in October (below) has been remarkably unchanged.

Sure, oil rose from the cut. But the real story is how powerful dollar’s pricing is behind oil’s future prices. And here is the real concern:

The Fed’s cut has two objectives:

• Lower credit conditions to ease lending strain, bolstering the economy
• In anticipation of further economic contraction, ensure deflationary conditions do not persist.

The Fisher Equation derives the market’s inflation expectations. Below is the previous Monday and Friday (before and after the Rate Cut) TIPS and Treasury Yields, and the derived inflation expectations.

No doubt treasury yields are low in an investor. But suppose treasuries were priced 100 -200 basis points higher. Given TIPS yields, there is still a view we are headed into a deflationary period. Given the dollar’s increased pricing power tomorrow vs. today, it should give us pause about the following:

• What is Oil’s true future price?
• Given that holding cash under the mattress is now worth more tomorrow than it is today, is the treasury fix fixing anything?