Daily Archives: December 12, 2007 @ 10:25 am (Wednesday)

Ip: intermeeting ease/action

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(an interoffice email) 

Thanks, and good call!
>
>
>
> Many I spoke to post-fomc talked about an intermeeting ease on the discount
> rate.
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> Also, that the Fed would use their mouthpieces (Ip,e.g.) to get a message
> out tomorrow if today’s reaction went poorly.
>
> So here we have it, Ip story tonight on potential discount rate cut within
> ‘days’
>
>

Fed Cuts Rates, Seeks New Ways To Thaw Credit
By GREG IP

December 12, 2007

WASHINGTON — With a deepening credit crunch threatening to drag the stalled U.S. economy into recession, the Federal Reserve cut interest rates for the third time since August, and left the door open to further cuts.

But yesterday’s cut, at the low end of Wall Street’s hopes, disappointed investors, who hoped the Fed would do more to thaw frozen credit markets. The Dow Jones Industrial Average fell sharply, undoing about a third of the run-up in stocks triggered in late November when top Fed officials first publicly signaled that another rate cut was likely. The blue-chip average ended the day at 13432.77, down 294.26 points, or 2.1%.

The Fed lowered its target for the federal-funds rate, charged on overnight loans between banks, by a quarter percentage point to 4.25%. It also cut the discount rate, at which it lends directly to banks, by the same amount, to 4.75%.

Fed officials, however, continue to consider ways of using various tools – including the discount rate — to combat banks’ unwillingness to lend even to each other, which they view as a threat to economic growth. The central bank could take action within days.

A variety of steps, widely discussed in the markets, are likely to be on the table, including another cut in the discount rate, longer-term loans to money-market dealers, easier collateral rules for loans from the Fed, and other complex steps last taken in 1999 to alleviate funding pressures ahead of the year 2000, when many feared a “Y2K” computer bug would disrupt markets and create economic havoc.

Changes in the discount rate can be made by the Fed board in Washington without the approval of the entire 17-member policy-making Federal Open Market Committee, which sets the federal-funds rate target.

Some on Wall Street yesterday criticized the Fed’s actions so far as inadequate. “From talking to clients and traders, there is in their view no question the Fed has fallen way behind the curve,” said David Greenlaw, economist at Morgan Stanley. “There’s a growing sense the Fed doesn’t get it,”

Markets expect a weakening economy will force the Fed to cut rates more, Mr. Greenlaw said. Futures markets expect another cut in January and a federal-funds rate of 3.25% by next fall.

In its statement yesterday, the Fed said that its quarter-point rate cut, which pushed the federal-funds rate a full percentage point below where it stood in early August, “should help promote moderate growth over time.”

The central bank didn’t, as it did in October, say the risks of weaker growth and of higher inflation were roughly balanced. That message was a signal that the Fed didn’t expect to cut rates again.

Instead, the Fed said yesterday it will to “continue to assess the effects of financial and other developments on economic prospects and will act as needed.” By avoiding any explicit indication of its next move on rates, the Fed left its options open for its next meeting in late January.

The FOMC’s 10 voting members approved the rate cut 9-1. Federal Reserve Bank of Boston President Eric Rosengren dissented in favor of a sharper, half-point cut. One FOMC member also dissented in October, but in favor of no rate cut. The shift in the dissents, from wanting less rate cutting to wanting more, symbolizes the swing toward pessimism at the Fed.

“Economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending,” the Fed said yesterday. “Moreover, strains in financial markets have increased in recent weeks.”

Unlike the previous two rate cuts, yesterday’s wasn’t portrayed as “insurance” against improbable but damaging economic scenarios. That suggests Fed officials view the economy as weaker than they expected as recently as late October.

Corporate executives are also signaling a more downbeat outlook. “I’m not going to put a happy face on this. Consumers are going to be a challenge in 2008,” General Electric Co. Chief Executive Jeffrey Immelt told investors yesterday. But global growth is “as strong as ever,” he added.

When Fed policy makers met in late October, financial markets were in better shape than they had been in August, and the economy had just posted a strong third-quarter performance. They chose to cut rates by a quarter point and concluded that would likely be enough.

But in subsequent weeks, markets reversed course as big losses tied to soured mortgage-related investments cut into the capital of major banks and other financial institutions, limiting their ability to lend. Fed Chairman Ben Bernanke and Vice Chairman Donald Kohn signaled their increased concern in speeches in late November, foreshadowing yesterday’s rate cut.

Even so, investors, who have persistently had a gloomier outlook than the Fed, were disappointed the Fed didn’t cut rates more or signal greater willingness to do so. Bond prices shot up and yields, which move in the opposite direction, fell sharply. The 10-year Treasury note’s yield dropped to 3.97% from 4.1% just before the announcement, while the two-year note’s yield, which is especially sensitive to expectations of Fed action, fell to 2.92% from 3.13%. Yields on corporate bonds rose relative to Treasurys.

Major banks, meanwhile, lowered their prime lending rates, the benchmark for many consumer and business loan rates, to 7.25% from 7.5%.

The Fed has found it especially difficult to discern the economy’s path and thus the right level for rates because the main threat facing the economy is the reluctance of banks and investors to lend to homebuyers, businesses and consumers. That’s harder to measure than the things like profits, inventories, employment and the Fed’s own interest-rate actions that usually drive the business cycle.

“Well, the boys blew it again. You wonder which economy they are looking at and what it is they are thinking about,” said Alfred Kugel, Chicago-based chief investment strategist for investment-management firm Atlantic Trust of Atlanta.

Brian Sack, an economist at Macroeconomic Advisers LLC, said that in 2001 the major shock to the economy was the stock market. “We have a better shot at trying to calibrate those wealth effects, whereas the credit turmoil has many dimensions to it. Frankly it’s hard to assess how much economic restraint you get from those various dimensions.”

In the past month, data on the so-called real economy has been soft but not dramatically so. Macroeconomic Advisers said yesterday it now expects the economy to shrink marginally during the current quarter, then grow at a 1.8% annual rate in the first quarter of 2008.

On the other hand, credit markets have tightened sharply. Since Oct. 31, the yields on securities backed by auto loans has jumped to 6.3% from 5.4%, while yields on securities backed by home-equity loans have jumped to 7.7% from 6.6%, according to J.P. Morgan Chase & Co. Rates on “jumbo” mortgages — those larger than $417,000 — are around 6.9%, up from 6.6%. The London interbank offered rate, the rate banks charge each other for three-month loans in the offshore market — is a whopping full percentage point above the expected federal- funds rate; it is typically less than a tenth of a point higher.

There isn’t yet evidence these higher rates have significantly bit into consumer spending, outside of housing, and the rates could drop after year-end funding pressures ease. But investors generally don’t expect that to happen.

A survey by Macroeconomic Advisers of its clients, mostly hedge funds and other sophisticated investors, found most expect little retracement of the wide spreads between yields on risky debt and Treasury yields by next year and most expect banks to curtail lending. “The possibility of a widespread pullback in credit availability is a significant risk to the outlook,” the firm said.

♥

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Roubini blog

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Roubini totally doesn’t get it.

The point of CB intervention is to keep interest rates at their target rates, not to provide funds for lending, as described in previous posts.

This plan will succeed at doing that, best I can tell.

It’s all about price, not quantity.

That’s all a CB can do.

Also, insolvency matters to the real economy only as it reduces aggregate demand.

The largest current risk to aggregate demand in my estimation is the media frightening businesses and consumers from spending.

That’s always a risk to a monetary economy where the government isn’t standing by to net spend when demand sags. When government does that there is little or no risk of negative growth or unemployment as we currently define it.

Nouriel Roubini | Dec 12, 2007

Given the worsening of the global liquidity and credit crunch – with a variety of short term interbank Libor spreads relative to policy rates and relative to government bonds of same maturity being even higher recently than at the peak of the crisis in August – it is no surprise that central banks were really desperate to do something.

The announcement today of coordinated liquidity injections by FED, ECB, BoE, BoC, SNB is however too little too late and it will fail to resolve the liquidity and credit crunch for the same reasons why hundreds of billions of dollars of liquidity injections by these central banks – and some easing of policy rates by Fed, BoC and BoE – has totally and miserably failed to resolve this crunch in the last five months. What was announced today are band-aid palliative that will not address the core causes of this most severe liquidity and credit crunch.

There has some heated debate in recent weeks on whether the liquidity crunch is due to:

  1. short-term year end liquidity needs (the “Turn”);
  1. a more persistent liquidity risk premium;
  1. a rise on counterparty risk and broader perceived credit problems of counterparties; i.e. serious problems of insolvency rather than illiquidity alone.
  1. a more general increase in risk aversion due to severe credit problems and information asymmetries (risk aversion due to uncertainty about the size of the financial losses and uncertainty on who is holding the toxic waste of RMBS, CDOs and other ABS products);
  1. the failure of the monetary transmission mechanism in a financial system where most financial institutions are now non-bank and thus do not have direct access to the central banks’ liquidity or lender of last resort support.

The severe financial crunch is likely due to all of the factors above; but the measures announced today can only partly deal with the first of the two explanations above of the crunch and will do nothing to address the other causes of the crunch. These measures will not be successful for a variety of reasons.

First, you cannot use monetary policy to resolve credit and insolvency problems in the economy; and most of the crunch is due not just to illiquidity but rather to serious credit and solvency problems of many economic agents (households, mortgage borrowers, subprime, near prime and prime mortgage lenders, homebuilders, highly leveraged and distressed financial institutions, weak corporate sector firms).

Second, monetary injections cannot resolve the information asymmetries and generalized uncertainty of a financial system where financial globalization and securitization have led to lack of transparency and greater opacity of financial markets; these asymmetric information problems that generate lack of trust and confidence and significant counterparty risk cannot be resolved with monetary policy.

Third, the US is at this point headed towards a recession regardless of what the Fed does as the build-up of real and financial problems (worst housing recession ever, oil at $90, a severe credit crunch, falling capex spending by the corporate sector, a saving-less and debt burdened consumer buffeted by ten separate negative shocks) in the economy make a recession unavoidable at this point; similarly other economies are also now headed towards a hard landing as the US real and financial mess lead to significant contagion and recoupling.

Thus, to mitigate the effects of an unavoidable US recession and global economic slump the Fed and other central banks should be cutting rates much more aggressively. The 25bps cut by the Fed yesterday is puny relative to what is needed; 25bps by BoE and BoC does not even start to deal with the increase in nominal and real borrowing rates that the sharp spike in Libor rates (the true cost of short term capital for the private sector) has induced.

And the ECB decision not to cut policy rates – and deluding itself that it may be able to raise them once the alleged “temporary” credit crunch is gone – is dangerous and ensures a sharp slowdown in a Eurozone where deflating housing bubbles, oil at $90 and a strong Euro are already sharply slowing down growth. Central banks should have announced today a coordinated 50bps reduction in their policy rates as a way to signal that they are serious about avoiding a global hard landing. Instead the Fed yesterday gave a paltry 25bps with a neutral bias rather than the necessary easing bias.

Fourth, the actions by the Fed today provide more liquidity to a greater variety of institutions but, as the Fed announced, these institutions are only “depository” institutions, i.e. only banks. The severe liquidity and credit problems affect today a financial market dominated by non-bank that do not have direct access to the liquidity support of the Fed; these include: broker dealers and investment banks that do not have a commercial bank arm; money market funds; hedge funds; mortgage lenders that do not take deposit; SIVs, conduits and other off-balance sheet special purpose vehicles; states and local governments funds (Florida, Orange County, etc.).

All these non-bank institutions do not have direct access to the Fed and other central banks liquidity support and they are now at risk of a liquidity run as their liabilities are short term while many of their assets are longer term and illiquid; so the risk of something equivalent to a bank run for non-bank financial institutions is now rising. And there is no chance that depository institutions will re-lend to these to these non-banks the funds borrowed by central banks as these banks have severe liquidity problems themselves and they do not trust their non-bank counterparties. So now monetary policy is totally impotent with dealing with the liquidity problems and the risks of runs on liquid liabilities of a large fraction of the financial system (in a world where these non-bank financial institutions play a larger role in financial markets than non-banks).

And let us be clear: the Federal Reserve Act striclty forbids the Fed from lending to non-depository institutions apart from very emergency situations that would require a complex and cumbersome approval process and the provision of high quality collateral. And the Fed has never – in its history – used this procedure and lent money to non-depository institutions.

Fifth, as discussed before on this blog, this is the first real crisis of financial globalization and securitization; it will take years of major policy, regulatory and supervisors reform to clean up this disaster and create a sounder global financial system; monetary policy cannot resolve years of reckless behavior by regulators and supervisors that were asleep at the wheel while the credit excesses of the last few years were taking place. Now the US hard landing and global sharp slowdown is unavoidable and monetary policy – if aggressive enough with much greater and rapid reduction in policy rates – may only be able to affect how long and protracted this hard landing will be.

♥

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