The Fed mulls an inflation target, to stabilize the economy. Robert Shiller and George Akerlof, in their new book Animal Spirits, argue for a “credit target”, a level of lending to keep the economy near full employment. In the middle is an old question - Should Central Banks consider Asset Bubbles a form of inflation?

Look at the 2008 Commodities Bubble:

• January 2nd, 2008 - According to the Financial Times, One month Oil Futures on the NYMEX were $99.62
• July 2nd, One month Oil Futures were $144.26
• December 30, One month Oil Futures were $39.03

That the Fed insists on Core Inflation, excluding energy, made it miss how energy moves all consumers prices. Consumers pulled back on gasoline purchases in the short term and in the long term, terminated SUV purchases, crippling GM and Chrysler.

Yet during oil’s rise, the Fed had to reduce the Fed Funds rate as the effects of Bear Stearns was first on its mind. It’s not clear the Fed could have raised rates to prevent oil’s rise, without crippling the economy.

Preventing the Housing Bubble though could have eliminated what we currently witness: Global de-leveraging and massive reassessment of household wealth. The sheer amount of leverage also helped fuel stock market booms (of which some was real) giving consumer confidence in 401k statements. Add to this the house market boom, household behavior such as reverse mortgages, credit card spending, an overall negative savings rates would probably not have occurred.

Yet the Fed’s role in determining over-investment is tricky, politically controversial. Without world-wide coordination for world wide bubbles, false arbitrage opportunities such as the Carry Trade can wreak havoc on international trade/commerce.

What Shiller, Akerlof, and all concerned about asset bubbles really want is an economy where the Financial Sector does not a) contribute the most to GDP growth and b) rise too disproportionately in terms of total GDP. This was our economy prior to this crisis. The economy must have real growth, not growth due to paper assets. Once perception is pricked on over priced assets, no one knows an assets true worth, causing trust and lending stop.

If Central Banks can not politically prevent asset bubbles, then our government must improve its risk management program. Two logical improvements are as follows:

1. Regulation and oversight must increase. Madoff’s false profits now cause hospital wings  to go without funding. Mortgage Originators are forcing real family pain on false interest rate promises.  And we all witness a loss in market confidence.
2. Running government surpluses in healthy economic times. 90 years ago, John Maynard Keynes worried about this very issue we now face. Certainly, government surpluses up until now would reduce our worry over how much debt we must now raise.

Only a start, but planning for the future must occur to prevent a future colapse of this proportion.

Yesterday’s news was not encouraging. Home value declines will continue to make families and home owners second guess their net worth. In a recession, this prompts only one reaction: saving.

The macro economic accounting identity states savings equals investment. This static steady theory is becoming a large force against fiscal stimulus, now awaiting Senate Approval.

Let’s review the facts. With the Fed meeting today, Fed Funds ended trading at 0.18% according to the Financial Times. As rates are not able to go below zero,  interest rates are essentially fixed. And bank reserves held at the Fed increase. There thus is no further mechanism to force private investment to equal savings.

As savings not offset by investment (which would lead to new jobs) and unemployment increase, taxes decline. If government expenditures just stayed the same, our federal deficit would have to increase, even without fiscal stimulus.

Faced with the choice of

• Large Federal Deficit
• Infrastructure Investments => New Jobs and a Large Federal Deficit

Its best to choose jobs, new infrastructure and a large federal deficit.

Today’s news was even less encouraging. That jobs are lost in record numbers makes valuing mortgage bonds, even if simply constructed, even harder. Yet mortgage bonds are not simply constructed, they are incredibly complex.

Job losses will not decelerate for a while. It will take time for fiscal stimulus to take effect. This makes the idea of the “bad bank” incredibly complex. Many like Reich still hold out hope for a solution that protects the tax payer. The economic reality makes it impossible that mortgage assets still on the books are worth anything close to what they were previously valued. To unclog lending, we -the taxpayer- must further take it on the chin.

Yet as the fiscal stimulus and bad bank solutions work through the economy (and slowly), we must ask ourselves: what kind of economy do we want to now create? Should the Financial Sector contribute 31% of GDP as it did in 2006?

Which should we value more? Financial engineering or mechanical engineering?

This is again why infrastructure investment as the stimulus for tomorrow’s economy is so important: The only way long term balance will be restored (and one could measure this by the current account balance) is to choose engineering over financial engineering. The more we build (not out of paper) at home, the more our economy will grow in a balanced, mature way for generations.

Much concern exists over Obama’s proposal to make tax cuts a major portion of fiscal stimulus.  Through a tax cut, we (the government) are increasing the income of those still employed. Hopefully, tax savings will buy goods and services, increasing GDP. In today’s environment, we’re not enacting a stimulus to buy goods, we’re enacting a stimulus to buy jobs.

GDP = government spending + investment + consumption + net exports. The marginal dollars in a tax cut will either be saved or spent.

While savings should be encouraged in the long term, a savings glut currently exists. Fed Funds rate trades near zero, while cash reserves within the Fed have ballooned.

More damaging, marginal spending could be directed at imported goods. From Martin Wolf to Warren Buffet, many shudder at no improvement in our trade balances. Dollars used for imports are either locked up as foreign reserves or exchanged for investments in future US cash flows. Those future cash flows are either US tax receipts or profits distributed as interest or dividends. Those tax receipts could have put new teachers in the class room. Those profits could have built new factories. Those cash flows will never to be re-invested in the US.

By definition then, an increasing current account deficit means the same standard of living - GDP - costs more. If this is not the purest form of inflation, I do not know what is.

Many believe  too great a mismatch exists between jobs lost and jobs needed for “shovel ready”.  Cokie Roberts on “This Week” opined on finance professionals helping on infrastructure: “Well maybe instead of going to their personal trainers, they can actually get out there and start digging.”

The purchase of infrastructure projects buys jobs across the food chain.  Almost every project will go out for private competitive tender. Forget defunct residential home construction (shovel ready employees), companies bidding will require talent to prepare bids, obtain financing, manage payroll, and review costs. Every contract guarantied by the government (state or federal) will give lenders the confidence to finance, spurring new growth.

The long term benefits (aside from jobs) are then improved transportation, reduced energy costs and reduction of barriers to education. Thus reduction of risks for future runaway inflation - those risks prevalent in increasing current account deficits. Faith in government is presently difficult yet now we must make our congress the direct investors of last resort.

This blog has focused on the FDIC insurance program guaranteeing newly issued bank debt.

Here is why:

Reviewing the facets of the right hand of the balance sheet, the taxpayer and printing press are very active.

• Short Term Liabilities, Commercial Paper - Guarantor - The Fed
• Short Term, Long Term Debt - Guarantor - The FDIC
• Preferred Equity - The Treasury

This blog believes the FDIC program is the most powerful government program helping banks currently expand credit.

A lot has been written on Credit Default Swaps. These unregulated instruments were instrumental in causing a crisis of credit, in turn causing a crisis of economic performance.

Let’s examine where these two issues meet: The Fee the FDIC charges banks to guarantee their new debt. This fee is the Credit Default Swap the FDIC (aka, the US Taxpayer) sells to guarantee new bank debt (from Goldman Sachs, Morgan Stanley to John Deere Capital).

What should the price of the swap be? Evidence from one source this month says as high as 7% or 700 bp annually of principal. The FDIC begs to differ. For any debt issued and set to expire more than a year from now, the FDIC is selling a CDS for 100bp, or an annual 1% of principal. While the CDS market is not transparent enough to determine the true price, it is fair to say 1% is cheap, or subsidized.

Is this enough? Is it even necessary to charge a fee or subsidize the entire swap?

• The FDIC states this program will be of no cost to the taxpayer.

• Right now, the FDIC has ~$33.4 billion in the bank, to guarantee this program as well as all accounts now $250,000 or less.

• Let’s assume most outstanding bonds covenants are written to ensure seniority is universally established in the event of a default.

• For the big banks, would the taxpayer just guarantee the debt sold with the FDIC swap? Comparing Lehman to Citi, the answer is probably not.

• Finally, given the lack of public savings, the taxpayer will have to return to the debt market should any bailout be necessary.

Is the FDIC program helping to fuel cheap credit? Yes. But given the US Fiscal Condition and its new precident of response to a crisis, the taxpayer should realize it is selling underfunded Credit Default Swaps just like the banks it now stands behind.

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.

Dec 15th and 16th are when the Fed meets for the final time in 2008, when it will decide how low the Fed Funds rate should be.

No ordinary time:

1. The Fed Funds Rate sits at 1.00%. But the Effective Rate as of Friday, Dec 12th according to the Financial Times was 0.14%
2. Fed Reserves normally are $800-900 billion. Today there are $1.5 trillion in Fed Reserves, according to The St. Louis Federal Reserve.
3. Treasuries normally pay positive interest rates. According to the Financial Times, overnight rates for three month treasuries are paying 0.03%. Further, the latest auction showed people are willing to pay the US Government more for less in the future. (deflation).

So what should the Fed do?

• Conventional wisdom leading up to this meeting was that the Fed would cut interest rates by 50 basis points from the current 1.00%.
• I argued in a previous post that only a 50 basis point cut would do nothing.
• Now, the expectation has shifted (maybe thanks to my Note….just maybe). CME Fed Binary Options prices as of Friday, Dec 12th show the market is betting on a 75 basis point cut.

The three major reasons against a 50 basis point cut are as follows:

• For some time, the effective Fed Funds rate has been trading below 50 basis points, making a 50 bp cut moot.
• With demand for Treasuries now essentially inelastic, part of the Fed’s open market operations are simply ineffective.
• Since the Fed’s rate cuts in the fall, bank lending has not responded. I argued in Note 16 one way to view this. Here is another: A look at the St. Louis Fed research shows M2 has remained largely unchanged from October 20th to December 1st. We need a resounding effort to get capital out of Fed Reserves and into the private markets.

A 75 basis point cut will occur by Close of Business, Tuesday the 16th.

But a 75 basis point cut may not help all that much without a spur of domestic demand.

• St. Louis Fed research shows corporate Aaa bond yields have remained largely unchanged over the fall: While base rates have declined, spreads have widened.
• The Commercial Paper Market has dramatically shifted from private market consumption to the Fed. According to the St. Louis Fed, in October, the figure of borrowing from the Fed was $450 billion. Today, it still is over $250 billion.
• This week, according to Financial Times data,  The American Express -now- “Bank” jumped on the bandwagon of FDIC backed debt raising, floating $5.5 billion of debt at yields of 2-3%.

In short, the Fed’s and other government’s massive expansion of credit market intervention is now more powerful than Open Market Operations. While the need for a 75 basis point is important and required, other actions are now more powerful to spur economic recovery.

Turning to 2009:

The fact-pattern above gives pause to how big a stimulus package needs to be vs. how quickly it needs to be spent. I am for a massive Fiscal Stimulus of at least $600 billion. But every dollar borrowed by the US Government (especially today) is a dollar unable to be accessed by Private Companies for new projects and investments, even in ZIRP land.

As Paul Krugman said today on “This Week”, it is hard to spend $600 billion dollars, even for the Government. Domestic Demand stimulus will only be effective therefore in boosting the private economy if “size” is optimally aligned with “velocity” and “accuracy of spending”.

Still, look for a 75 basis point cut this week as the final message of 2008 in preparation of massive fiscal stimulus in early 2009.

Robert Shiller, in his book The Subprime Solution offers a risk management tool for governments. It is a “Trill” and it pays a perpetual share of GDP.

As GDP increases, the instrument pays a higher coupon. During a recession, it pays less. Quite the floating instrument. Shiller assumes each share would pay roughly $15, believing perpetual GDP would average $15 trillion annually. (Hence the “Trill”). Each Trill would be worth roughly $300. This assumes the US Risk Free rate is 5%. The risk-less rate of the US economy is 5%.

The “Risk” that is managed is during hard times, the government obviously owes less in debt service costs. In times of plenty, the government can afford to pay more. But in bad times, governments would have more cash on hand to handle a crisis (such as today).

The Pros.

• This instrument allows the market to truly estimate GDP growth. In some ways, the instrument is worth issuing simply to have a market view (a great view) of GDP growth.
• One now has the ability- with TIPS, Treasuries, and Trills- to estimate real GDP growth given  market views.
• Instead of perpetual Instruments, it could be more beneficial to issue “Trills” expiring annually, similar to TIPS and Treasuries. This way, one could have the market truly predicting GDP growth.

The Reasons for Pause:

• Reviewing the LM curve, as output grows, interest rates rise. As the economy falters, interest rates fall. Even in today’s crisis, this relationship holds true. The Trill’s desired hedge already exists. Further, this means the government has the ability to re-finance higher yielding paper in tougher times.
• The Hedge: Shiller’s main reason for the GDP indexed Trill is to provide government “room to spare” should a contraction occur. As GDP declines, so would tax receipts, lowering government revenue. It then is hard to argue the Government would have spare cash to attack a crisis.
• Other Financings: GDP, remember, is defined as Consumption + Investment + Government Expenditure + Net Exports. GDP could remain stable year on year, but Imports could still rise. In this example, Investment (Foreign Direct Investment) remains unchanged meaning the Current Account Deficit is in the form of domestic bonds and stocks, essentially payments to foreigners from US income. Trill payments could remain unchanged, but the country as a whole would pay more to maintain the same standard of living (in the short run).

Robert Shiller is one of our smartest thinkers on real property. Let’s work on the Trill as it has definite promise as a positive instrument for US Debt.

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 a randomly selected May 16th, 2007, the Federal Funds rate was 5.25%. The effective rate (the rate bankers actually trade and negotiate at) was 5.29%. The actions taken by the Fed ensured its “target base rate” was the actual base rate for charged money. In short, this is our monetary system we take for granted, daily.

Before the credit crisis, how did the Fed ensure the spread between the target and effective rate stay so close to zero (if you know this, please skip down)?

• Banks are required to hold a certain amount of capital at the Federal Reserve. Prior to the crisis, a banking business model was to lend to outside parties. When lending exceeded required capital reserved at the Fed, banks had to borrow to repatriate to the Fed.
• The first choice of funds to borrow is capital held by other banks at the Federal Reserve.
• Should other banks charge too much for these funds, banks seeking capital could simply short treasuries.
• The Fed would mimicked this action,  buying and selling treasuries to ensure the market price for treasuries kept banks honest in pricing overnight lending.
• Sure enough, on May 16th, 2007, overnight LIBOR was 5.30%, one basis point from the effective rate and five basis points from the target rate.

Today, the story is quite different. The Federal Reserve’s target Federal Funds rate is 1.00%. The effective rate, (from the Financial Times), is 0.49%.

Two implications:

• Almost everyone surveyed, interviewed, and opining (including me) expects the Federal Reserve to slash the target rate from 1.00% to 0.50% in December. That decision is now moot.
• When the effective rate is nearly half the target rate and overnight LIBOR is 0.70%, in between the two rates, and yields on treasuries expiring on November 30th are 2.67%, there is a problem of illiquid markets, not responding correctly to simple centralized decisions attempting to steer the economy. To quote Senator Trent Lott, we are now “herding cats“.

How and why?

Reviewing the minutes from the last Federal Open Market Committee meeting and events of the “credit crisis” I find several issues:

• Randomly sampling daily market rates, the spread between target and effective rates was not large enough to be significant until after the bankruptcy of Lehman Brothers, on September 15th, 2008.
• By September 22nd, 2008, while the target rate was still 2.00%, the effective rate was 1.79%. By the end of that week, the effective rate was 1.21%. In short, capital required to be in the Fed was not going anywhere: thus the start of banks truly refusing to lend.
• So, the Fed on October 6th, 2008 started paying interest on held capital, attempting to establish a floor on effective rates. Most important, the Fed started to pay interest on excess cash held above any requirements.
• But by October 10th, 2008, the policy wasn’t working. While the Fed slashed rates from 2.00% to 1.50%, the effective rate was 0.90%.
• By October 21st, the effective rate hovered below the floor rate established by the Fed on October 6th, 0.73%.
• So, the Fed again in two different announcements, the latest on November 5th, raised the interest rates paid on excess balances. As of today, any excess capital receives the target rate.

We’re still in the same position and I highlight what is explained beautifully in a recent Financial Times article:

• Most of today’s spread is explained because our Government Sponsored Entities, Fannie Mae and Freddie Mac, hold reserves at the Fed. Yet they can not receive interest payments, and thus must lend their capital at the effective rate.
• As banks are queasy regarding their own reserve requirements, they do not want to borrow entity funds for opportunities.  This capital simply sits at the Federal Reserve, depressing the target rate.

The Bottom Line:

• BANKS ARE NOT LENDING. If Banks were lending, there would be no need to pay interest on excess reserves.  That capital would be privately lent, to businesses large and small, old and new.

The Fed now has de-facto set a larger reserve requirement for banks, by paying interest on excess reserves. This is very dangerous.  That excess cash that should be in the market, growing our economy. (As I heard in business school again and again “putting capital to work”).

While overnight LIBOR has trended up since the Fed’s latest announcement (from 0.33% to 0.70% and most likely will continue up to 1.00%), the larger problem is this: For growth opportunities of the US Economy, the same target rate on a larger reserve pool of capital is equivalent to a higher rate on the official “reserve requirements”.

Therefore, when the Fed does cut rates to 50 basis points, what effect will it have?

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.