March 19, 2008
How much ammo is left in that fed funds gun?
Interesting reaction yesterday at the Chicago Board of Trade to the Fed's decision to reduce its target for the fed funds rate by 75 basis points to a new objective of 2.25%. On Monday, the fed funds futures contract had been anticipating an average funds rate of 1.95% for April, consistent for example with a 100 basis point cut yesterday and some weakness prior to another 25 bp cut at the April 29/30 FOMC meeting. However, after yesterday's meeting, the implied April interest rate shot up 20 basis points to 2.15%. The Fed made a big cut, and the market was surprised that it wasn't even bigger.
To put these numbers in perspective, prior to January of this year, the Fed had not made a cut as large as 75 basis points in a single move in the available 25-year history of the series. And yet now we've reached a point where we're surprised when the cut is "only" 75 basis points.
Still, I am glad to see that the Fed recognizes the need for at least this much restraint. I say that not because I am still mechanically thinking about a tradeoff between promoting real GDP growth and containing inflation. I think we are past that now. I could easily imagine this weekend's developments with Bear Stearns as only the initial carnage in what may prove to be a very bloody financial crisis. I accept the view that job 1 is to try to contain that damage.
But suppose you believe that oil over $100 a barrel is a destabilizing influence-- and I do-- and that the Fed's recent decisions on the fed funds rate are the primary reason that oil is over $100-- and I do-- and that further reductions in the Tbill rate have limited capacity to stimulate demand-- and I do. Suppose you also saw a risk that the inflation, financial uncertainty, and slide of the dollar could precipitate a run from the dollar, introducing an international currency crisis dimension to our current headaches.
Well, if you did, then even if you were very, very worried about our current financial problems-- and I am-- you would still want to draw the line somewhere, and acknowledge that there is some point beyond which lowering the fed funds rate further will do more harm than good. When we've got that rate to 2.25%, and people are telling surveyors they are expecting 4.5% inflation, we need to be open to the possibility that we've already reached such a point.
I think the Fed missed an opportunity here. A 25 or a 50 basis point cut would have sent commodity prices crashing. Even the mildly hawkish surprise of "only" a 75 basis point cut may have some effects in that direction. If the Fed did convince the commodity speculators that their path leads only to ruin-- and I believe the Fed could easily have done just that-- that would leave Bernanke with a lot more maneuvering room to cope with what comes next. If the commodity demon were under control, maybe we'd have the breathing room later to bring the fed funds rate all the way down to 1%. While the speculation remains rampant, however, I expect to get nothing but trouble for the effort.
The Fed is firing its gun into the air. We may soon really wish we had some more ammunition.
Posted by James Hamilton at March 19, 2008 05:00 AMdigg this | reddit
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Tracked on March 19, 2008 07:24 PM
The Cleveland Fed's implied probability chart shows that the expectation of a Federal Funds rate of 1.5% after the April meeting was about 85% as of Monday. The probability fell to 40% after the FOMC statement.
Posted by: GWG at March 19, 2008 06:09 AM
At 10:40 am EDT:
VALUE CHANGE % CHANGE
Oil 105.90 -3.52 -3.22
Gold 957.60 -46.70 -4.65
Nat Gas 9.24 -0.17 -1.81
Posted by: Fat Man at March 19, 2008 07:41 AM
Krugman recently blogged his praise for expected inflation, arguing that this gave the Fed more, not less, room to stimulate the economy. His argument was the obvious one: nominal rates have a zero lower bound (and he noted that t-bill yields are nearly there) so higher expected inflation increases the FRB's ability to stimulate demand by lowering real interest rates.
Your March 11th note (referenced above) notes that inflating away the housing price overvaluation is not a serious option. Fine. However, I don't understand where you feel the fault lies in Krugman's logic. Is it that, given constant nominal interest rates, higher expected inflation will not be stimulative? (e.g. a vertical supply curve?) Or that economic stimulation will not mitigate the negative effects of the housing bubble collapse? Or something else that I've missed?
Posted by: SvN at March 19, 2008 07:45 AM
Talk bout time inconsistency:
Did i read that last paragraph right?
If on the FED has ease less... today... it would enable them to ease more in the future?
Some place along that path you're going to violate the law if iterated expectations..
By the way is the counterfactual true? If the ease more now that means they' have to tighten more in the future?...
Or isn't that one just as silly?
Posted by: phyron at March 19, 2008 09:04 AM
If commodity speculation is such a problem, why not just jack up the margin requirements on commodoity trades and otherwise crack down on speculation in commodities with borrowed money?
Posted by: jalrin at March 19, 2008 09:07 AM
jalrin-marging requirements are determined by the exchanges themselves. you might need legislation to change that.
not giving the markets all they anticipated has done quite a job on inflation speculating via gold and oil so far today. gold down over $50
Posted by: oops at March 19, 2008 09:54 AM
One of the "signature" Obama stump speech lines refers to "the same people repeating the same actions expecting a different result."
Here we have supposedly intelligent, educated "folks" expecting that another iteration of a "1% solution" will do anything other than engender another crisis, inevitably even worse than the current one.
The absolute unwillingness to actually solve a problem rather than just attempt illusory and bogus fixes constitutes a cultuaral character disorder in the United States,
probably a fatal one.
Perhaps it is inevitable that a greatest generation be followed by, well, this lot.
Posted by: esb at March 19, 2008 10:03 AM
The Fed always goes too far, in both directions.
In 2000, they made the rate 6.5%, which was too high. Then they lowered it all the way down to 1%, which was too low. Then they increased it back to 5.25%, which was a bit too high.
Now we are going too low again.
I think there is hardly ever a reason to go below 3% or above 5%. Why not just stay in that range, and let the market sort things out at a natural rate.
We have dropped 2% in just 7 weeks. This will lead to over-stimulus by Fall once again.
Posted by: GK at March 19, 2008 10:57 AM
My understanding of the link between interest rates and commodity prices comes via storage incentives. Increasing the interest rate (or not dropping it as much as expected) would presumably cause speculators to sell their accumulated stocks of commodities, pushing down current prices relative to expected future prices.
But I have a hard time buying this story in the current situation with commodities. Stocks are already very low by historical standards. There isn't much left to sell. At least for agricultural commodities, anyway.
Or do you think everything is tied to oil prices? That may be possible with ethanol taking such new prominence. I haven't been following oil inventories, but are those high enough to induce big price movements from interest rate increases? Haven't you argued that there are fundamental production constraints right now, that everyone is producing and selling as much as they can, maybe even including Saudi Arabia?
Or is there an interest rate/commodity price link that I'm not aware of?
Posted by: mike at March 19, 2008 11:00 AM
Syn: I'm arguing among other things that pushing real interest rates to even more negative numbers causes changes in relative prices that can have distortionary and destabilizing effects.
phyron: I believe there may well be a psychological component that's adding on to fundamentals here-- some folks see commodity prices booming and try to jump on the bandwagon without really knowing what they're doing. Break that psychology and you only have to deal with the fundamentals component.
But even if it's pure fundamentals, there's no question that expectations of what the Fed is going to do matter for the effects of its actions. A Fed that has clearly persuaded everybody that it is not going to allow a resurgence of inflation can certainly accomplish more than one whose intentions the public is always second-guessing.
Case in point-- the Miller Fed could never have brought the fed funds rate to 2.25% in the present environment. Bernanke could because he had some credibility, and that credibility is a valuable asset he has right now for purposes of dealing with the credit problems. But I'm not sure he has the credibility to bring the rate to 1.0% in the current environment. A Fed that had only gone to 2.50% at the latest meeting would have.
Posted by: JDH at March 19, 2008 11:35 AM
Before anybody goes and makes a strong connection between the latest Fed action and the sudden downdraft in the CRB, gold and the like, note that at least one big commodity broker in on the skids. That rather distorts pricing in the short term.
Posted by: kharris at March 19, 2008 12:36 PM
It just appears to me what the Fed have be doing is creating a new bubble to replace the old one, a real estate bubble to replace the tech bubble, now a commodity bubble to replace the real estate bubble.
Posted by: Retirement Investment at March 19, 2008 03:41 PM
"a real estate bubble to replace the tech bubble, now a commodity bubble to replace the real estate bubble."
That may not be a bad strategy given the circumstances.
Instead of have a 10-year depression from 2001 to 2011, divide it up into three 3-year downturns, with 5-year respite's between them. The correction is gentler and more easily digested. Also, the brunt of pain of the final bubble popping (2015 or so) will be felt on China and the Middle East, rather than the US.
So not a bad strategy, perhaps.
Posted by: GK at March 19, 2008 04:08 PM
If the market wants to speculate on commodities prices going up then someone needs to store them.
But inventories are almost zero.
So it is hard to say commodity prices are a bubble.
For the same reason it is hard for me to see how Fed actions have any influence on commodity prices.
Paul Krugman has now realized this basic point.
JDH: I'm curious to hear how you reconcile your views with facts about inventories. I've read Professor Frankel, but I'm not convinced. There seems to be something I'm missing.
On the other hand, I can see how fundamentals are driving commodity prices. Demand growth is profound, with ethanol and Asian economic growth the main culprits. Across the broad range of commodities, supply growth can't keep up. This makes me think it's fundamentals driving commodity prices.
But if we just look at recent events, the correlations suggest there may be link to Fed actions, the dollar, and interest rates. I just don't see the mechanism through which these links could be causal. I'm not saying they aren't, but I have yet to see a compelling explanation.
Posted by: Michael Roberts at March 19, 2008 05:17 PM
It will be interesting to see if monetary base growth has picked up since january. Last years interest rate cuts did nothing to buck the downward trend in monetary base growth.
At the risk of being accused of being an unreconstructed monetarist, I think the slow growth in monetary base is alarming.
For starters, basic monetary theory (shared by monetarists, Tobinesque old guard Keynesians and New Keyensians alike) suggests that the first stage in the monetary transmission process for monetary stimulus should involve an increase in the monetary base. Additionally, the asset market crisis should ential a 'flight to quality', which would stimulate monetary base growth under interest rate targeting.
Monetary base has a much better track record for forecasting inflation and nominal GDP growth than M1 or M2; it is easier to adjust the base for the institutional changes cause the poor performance of these aggregates. Maybe we should be looking at St Luois adjusted monetary base, and not just the negative short term interest rates, in assesing US monetary conditions.
Posted by: Tim Peterson at March 19, 2008 07:58 PM
"To put these numbers in perspective, prior to January of this year, the Fed had not made a cut as large as 75 basis points in a single move in the available 25-year history of the series."
"For perspective, the single biggest reduction on record was made in October 1984 when the Fed, then under Paul Volcker, cut the federal funds rate by a hefty 1.75%, from 11.75% to 10.0%."
which should have been in Thornton's WP, used as the source of the 1982-93 data.
Which doesn't, of course, invalidate the points made, most especially including that 75 was too much (my HELOC notwithstanding).
Posted by: Ken Houghton at March 20, 2008 11:24 AM
Ken, according to Thornton's series, as currently maintained and distributed by FRB St. Louis, you are actually referring to a series of cuts: from 11.5 to 11.25 on Sept. 20, 1984; from 11.25 to 11.0 on Sept. 27; from 11.0 to 10.5 on Oct. 11; and from 10.5 to 10.0 on Oct. 18. The Washington Post story you quote from is evidently combining all of the moves over these two months together, whereas I was specifically and intentionally referring to "in a single move."
Posted by: JDH at March 20, 2008 11:43 AM
JDH, So now you believe "that oil over $100 a barrel is a destabilizing influence". Didn't you publish an article a few months ago saying that oil would have to go to $150 to be a brake on the economy? It had a lot of macro-economic analysis. And didn't I say that $100 a barrel would be a problem because the published analysis ignored the changes in the (micro-economic concept) fixed vs. variable costs that have occurred since the 1970s and 1980s.
But your catching up is better than Bernanke, who has been and continues to be behind the power curve. That's why he is stuck in crisis management mode. He didn't take action a year and an half ago when it was evident that bad mortgages were being written by the billions. His inaction wiped out Bear Stearns and several smaller firms. If he were a CEO, he'd be fired.
BTW, what are your thoughts on recession. I said in November that well defined criteria had triggered, and that a recession had started or would start in a month or so. Have your equations spotted recession on the radar screen?
Posted by: Mike Laird at March 20, 2008 01:13 PM
Sorry guys, but talk of a commodities bubble seems just plain silly. Take a longer view--we are allowed those, right?--say from the late sixties or early seventies (what followed into the late seventies, now that was a bubble!) and plot the CRB relative to the S&P, and you'll see that what's happening now is barely visible. And in terms of looking to commodities as the next asset class to inflate to bubble status; if, presumably, the idea in doing so is to create enough wealth for the economy to keep chugging along despite the lack of growth in compensation, commodities are uniquely ill-suited for the task, given that as they rise in price, they put constraints on growth. Finally, given its market cap, relative to, say, the housing stock or total equity market capitalization, if commodities were to inflate enough to have an impact in terms of wealth creation, we'd be in serious trouble.
Posted by: Scott Frew at March 21, 2008 07:31 AM
Mike, I think we're seeing evidence now of problems with car sales that weren't showing up as of last November, and consumer sentiment readings are also deteriorating. I was surprised at how little response there had been earlier to oil prices, and wanted to wait for more data before concluding oil prices are now making a meaningful contribution.
On the recession probability index, remember that this is a retrospective measure describing where the economy was in 2007:Q3. I'll update numbers for 2007:Q4 when the 2008:Q1 advance GDP report comes out April 30.
Posted by: JDH at March 21, 2008 09:07 AM
Gasoline inventories in the U.S. have never been higher than they are today. Total Petroleum inventories (oil and products) in the U.S. are above the 5 year and 10 year averages on an absolute and days of demand basis. US oil demand is down 3% year over year over the last four weeks. OECD total crude and product inventories are above the 5-year and 10-year averages. OECD demand has been negative year-over-year in 8 out of the last 9 quarters. China's oil demand has been below their 10 year average growth rate for each of the last four quarters. India's industrial production (released on 3/12) shows that their economy is decelerating at a rapid pace. Think about this fact. Many people say oil bears are too U.S. centric and are missing the China story. Never mind that China’s oil demand growth has been below trend for over a year now. If U.S. oil demand is down 3.0% year-over-year, China’s oil demand would have to grow by over 8.0% just to offset the U.S decline as the US still consumes almost 25% of World oil demand. China has not had that type of growth since 2004 (and this demand was driven by the power shortage which drove everybody to buy their own inefficient oil powered generator.) Anyone who thinks oil prices are being fundamentally driven are drinking the Kool-Aid.
Posted by: JEH at March 22, 2008 01:14 PM