Thursday, August 30, 2007

Rate cuts

There continues to be a debate about whether, when, and by how much the Federal Reserve Open Market Committee will cut the Federal Funds rate.

In today's edition of The Wall Street Journal there is a discussion of whether, and how, Ben Bernanke differs from Alan Greenspan in responding to markets.

What is particularly interesting is that the article claims that "The Fed historically has had two major economic duties. Maintaining financial stability is one. Controlling inflation while preventing recession is the other."

In fact, the Federal Reserve Act states:

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates (emphasis added).

Essentially, the Fed is supposed to maintain low unemployment and low inflation, which conventional economic theory - the Phillips Curve - states requires a trade-off.

Happily, the Phillips Curve relationship seems to have been broken (or at least weakened) as we have experienced low inflation and low unemployment for more than a decade.

At present, there continues to be a risk of an increase in inflation, which makes it difficult for the Fed to justify a cut to the Federal Funds rate. That is why, in an earlier post, I stated that the discount rate was a master stroke. It improved liquidity in the banking system without risking inflation.

The economy needs to be monitored, but there is little indication - right now - that unemployment is increasing to an unacceptable level.

This is why I have agreed with the Federal Reserve's actions in the current market turmoil.

In 1987, our economy was suffering from more than double our current inflation rate and the unemployment rate was over 6 percent.

In 1998, the markets were frozen because of counter-party risk concerns. The situation was concentrated on one hedge fund and the cut in Fed Funds could be justified (although a discount rate cut at that time might have proven as effective).

Chairman Bernanke's actions do not provide much support for a belief that he would have chosen different policies than those employed by Chairman Greenspan. The environment in which current decisions are being made is markedly different than those that existed in past crises

Over the last several years investors have been willing to assume greater levels of risk, to the point where interest rate spreads were at unprecedented lows (at least I can't remember a time when spreads were as low as they were a few weeks ago).

In my opinion, the assumption of risk wasn't driven by reckless disregard. It was, rather, driven by a strong need for greater yields. Pension funds and other investors had maintained reserves to support future obligations based on assumptions that investment returns would be at a higher level. If they are forced to recalculate their reserve requirements based on lower investment returns, they will have to make up significant deficits.

In my opinion, the flood of funds into alternative investments and the willingness to invest in untried asset-backed structures was driven by the desire to minimize the need to accumulate more assets to cover those future liabilities.

It is also my opinion that the reason that there was so much capital chasing investments (compressing returns) was primarily related to the need of foreign countries to park their trade surplus dollars. The United States and, to a lesser degree, other developed countries offer a level of value retention and liquidity that would not be available in their home markets. Repatriating these funds would lead to inflation and the funding of irresponsible projects.

I believe this is also why the yield curve has been distorted for the last few years. There is a lack of supply of long dated Treasury securities, so there was too much capital chasing a relatively limited supply (a little less than $500 billion of the $4.4 trillion of marketable Treasury securities have terms of 10 years or more, and a little over $1 trillion of securities have maturities of 5 years or more). China, alone, has over $1 trillion in foreign reserves.

The recent market turmoil was, in my opinion, primarily a recognition that the returns on risk were insufficient - and significantly so.

As long as markets continue to function, there is little need for an interest rate cut.

If inflation numbers start to dip consistently to the lower part of the range, or unemployment starts to tick up, there will be a need to cut rates. By not using that tool now, the FOMC maintains an ability to make any future moves more effective.

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