(an email with Randall Wray) 

On Dec 11, 2007 10:49 PM, Wray, Randall <WrayR@umkc.edu> wrote:
> Warren: very respectfully, I suggest you might reconsider both your model of the fed’s reaction function as well as the likely course of the “real” economy.
>
> Whatever the fed might have said about “fighting inflation” back last summer is not relevant to near- and medium-term policy. The fed is scared nearly out of its mind about financial mkts and spill-over to the “real economy”. Further, it realizes all inflation pressures are in sectors over which it has no control, and that are just “relative value” stories. Yes, there can be some feed thru effects to nominal values, but the Fed can’t do anything about it. Inflation will not enter the Fed’s decision making in the near and medium term. Yes, they will continue to pay lip-service to it, since their whole strategy of inflation management relies on expectations. But they are far more concerned with asset prices, financial markets, and, less importantly, economic performance.

Already agreed.  As Karim says it, they want to put the liquidity issue to be first, then worry about inflation.
I’m guessing that the ‘new’ liquidity facility they just announced that will be used to set rates over year end for member banks with a greatly expanded list of acceptable collateral may do the trick.

If so, much of the ‘fear’ is gone, and it’s back to the more traditional and ‘comfortable’ inflation vs the economy, which is a
whole different ball game.

>
> The “markets” are also scared out of their minds. Maybe they are all completely wrong, and you are the lone voice of reason. Maybe nothing is going to spill-over into the real sector. But it is worth considering that MAYBE they are correct.

I do give that some weight.  Maybe 25%?  And with govt, pensioners, and indirect govt sectors not going to slow down, the rest has to slow down quite a bit just to get to 0 real growth.  In fact, I see the biggest chance of negative growth coming with ok nominal growth but a high deflator due to statistical variation.  Nominal shows no signs of slowing, and it is a monetary economy.

 My continuing point, however, is that it’s not happening yet, nor is anything I’m seeing that is yet showing actual weakness, apart from so far anecdotal statements about retail sales, and the .2 nominal personal spending number last reported. I have also seen nothing but low gdp forecasts getting revised up continuously.  Maybe that changes.  However, if demand does weaken, I’m not sure it would be due to the financial losses as I still see no ‘channel’ from that to the real economy, apart from  CNBC scaring people into not spending, and that is not a trivial effect!  But so far there doesn’t seem to anything reducing personal income, and borrowing power seems reasonable if the desire is there for (now cheaper) homes, cars, computers, etc. with a non trivial amount coming from export earnings, which seem to be going parabolic.
> In any case, it will probably help you to predict what mkts are doing if you consider that they REALLY believe we are headed for a hard crash, and that this is not just media manipulation. They could be completely wrong. But at least we can predict their behavior.

I hear you, and in fact that has been my explanation of why they 50 in Sept, and then 25 in Oct- blind fear of the unknown/crash landing. But how does that explain yesterdays outcome?  It was at the very low end of expectations.  They even were stingy on the discount rate spread, which costs them nothing in terms of inflation.  All you can say is they were trying to avoid moral hazard risk, which indicates a lot less fear of hard landing than previously, along with reasonably
harsh language on inflation to ‘explain’ to the markets the stinginess of their actions?

>
> I do agree with you that there will be a reversal tomorrow, and after every disappointment at the Fed’s actions. But that is froth. Mkts have to take profits where they can find them–and after 300 points down, the mkt looks cheap. Yes, mortgages are being made. Yes, investment banks will buy-out insurers (to minimize losses–even if the insurers eventually go bankrupt), and so on. You get profits where you can, or you lose all of your business.

Right, a basic driver of capitalism.  The old ‘fear vs greed’ pendulum.

>But massive losses and write-downs will continue. Maybe they are
wrong to do it; maybe it is just paper shuffling; but it is worth
considering that after a few trillion dollars of losses, there could
be a real effect on the economy.

Sure, but you know as well as anyone the real economy is a function of agg demand.  And there’s been no credible channel discussed of how agg demand gets reduced that’s showing up anywhere in the data.  To the contrary, the non resident sector has suddenly become a source of demand for US output that’s already more than made up for the outsized
and sudden drop from the housing sector, as the bid for housing from sub prime borrowers vanished.  That’s an example of a major demand channel vanishing that could have taken the economy down, but was coincidentally rescued by the foreign sector.  The present value gains from the new export demands are roughly offsetting the pv losses from the sub prime bid vanishing.  Hence, equity markets are up about 10% for the year.

The siv’s, the spv’s the junior tranches, and the super senior tranches all have massive negative present values. Yes, if we can ride it out, in 10 years they could all come back. As keynes said, life is too short.

We don’t have to ride out anything if our purchasing power is unchanged at the macro level, and we can sustain demand for our output.

>
> Even if all we are interested in is to predict what the fed and mkts are going to do, it is worth considering that the Fed BELIEVES it is fighting a Fisher-type 1930s debt deflation that will bring down the whole economy, and that most in the mkts also believe that is a plausible outcome.

Agreed!

>They might all be crazy. But they can be self-fulfilling.

yes, as above.

>So far as I know, EVERY former fed official who is now free to speak
is projecting more rate cuts and recession and maybe worse. That
includes mister inflation hawk Larry Meyer (for whom I TA-ed). The
notion that inflation is a problem just is not going to get traction.
maybe not.  but they all blow with the wind- especially the media- and after this weeks inflation numbers we’ll have a better idea.

>
> I could be wrong, but I’m not paid to be right! I view it all as a bemused spectator. However, millions of Americans WILL lose their homes. Maybe they shouldn’t have them. I do not know, but I do lean toward the view that they should and that policy ought to aim for protecting home ownership. In any case, I find it very hard to believe that will have no effect on the economy.

We’ve already had the effect, as above, and it’s been offset by export earnings, at least so far.  Maybe ‘millions’ will lose ownership, but they won’t be unemployed and homeless.  They will rent, or get owner financing, or get bailouts from relatives, etc.  Mtg rates are down from last summer, affordability is up, and employment is relatively high as well.

The only thing to fear is CNBC itself.

Thanks!!!

Warren

> L. Randall Wray
> Research Director
> Center for Full Employment and Price Stability
> 211 Haag Hall, Department of Economics
> 5120 Rockhill Road
> Kansas City, MO 64110-2499
> and
> Senior Scholar
> Levy Economics Institute
> Blithewood
> Bard College
> Annandale-on-Hudson, NY 12504