patrick.net

Randy H Says:

My view of soft-landing v hard-landing has shifted a little further towards soft.

It still seems possible to me that BB's wussing out will only serve to delay the inevitable correction. As all asset bubbles are inherently unstable, an alternative outcome is that this will make for a harder landing in the end, just farther down the road.

Long & short rates already dropping, but yield curve maintaining inversion:

http://www.bloomberg.com/markets/rates/index.html

Maybe we are in for a Japan-style "soft landing." Unfortunately, 20 years later they are just now starting to take off again.

I prefer the Volcker approach. Get it over with. Like ripping off a band-aid.

From ben's blog --thought you'd appreciate it:

Comment by moqui

last week; buy now b/c rising interest rates will price you out of the market forever.
this week; buy now b/c rising inflation will price you out of the market forever.
Realtors confuse Mongo...

Will the pause effect cd rates? I'm short term right now - should I look into longer term cds? I'm worried about my down payment savings.

lanarpark,

In my opinion, there's not a huge amount to worry about unless your savings are pretty large. If you're talking about enough $, then look into a large fund group like Vanguard. There are lots of tax-exempt and tax-managed vehicles there that will beat CD rates at a very low risk profile.

Randy,

Thanks. I appreciate your input. I'm going to check out Vanguard.

Randy,

I have been wondering the same. How "safe" are the money market funds ? Esp. the CA tax exempt ones ? If FDIC is 100% on scale of safety, are these 99% ? How do I determine their risk ? Historically, they have been very safe. But can a long term recession increase their risk ?

Thanks in advance.

Stuck,

(here we are talking only about market risk, not inflation risk, which complicates things tremendously)

I personally think the money funds are pretty safe. They are 100% safe up to 100K for FDIC deposits. Call those a market risk of 0, and the S&P a risk of 1.0, then most of the Tax-Exempt money & bond funds come in 0.2 or lower. I think Vanguard has one that ranks about 0.3, but it is a short-term tax-exempt bond fund with a small portion invested below premium. Maybe it's an ultra-short fund, now that I think of it.

I'm not affiliated with these guys, but I recommend them often to friends and family because I like their approach:

http://www.financialengines.com

They use a pretty sophisticated Monte Carlo simulation to do a mean-variance-optimization of your investment based upon whatever goal and time frame you set. Most of it is retirement-focused, but I've used it to set up home-purchase goals for folks. It lets you carefully evaluate the riskiness of any portfolio, and then you can slide a little bar up and down to fit your own sentiment.

It's a pay service. Not free though.

As for the risk of commercial paper suddenly failing, you're talking about the simultaneous destruction of the balance sheets of just about every public corp in the US and most globally. I'm not going to stay awake worrying about that.

If you want to factor in inflation then you need a much more sophisticated model. Mainly because various stocks/sectors/funds have different exposure to inflation.

SGV,

Thanks for the repost. Obviously some of that was satirical and some of it wishful thinking, but I still stand by the reasoning (except for the last couple of points which are my dream).

The problem is this:

* But the Fed has to raise rates again and again to keep inflation in check.

If that point fails to occur, then all bets are off. At least for now, that is the case. Many FedWatchers are saying today's comments signal an end to rate increases, not just a pause. In fact, the market priced in about a 20% chance of a CUT at the next Fed meeting, at least according to some talking head on CNBC (I'm not a Fed Watcher, so I cannot independently verify this, but someone here will correct me).

If rates EASE, then inflation kicks up -- continuation of the credit bubble. Here's my forward looking view based upon that possible case:

* The Fed Eases rates.
* Inflation ticks up much worse than my previous scenario.
* But, it is largely hidden at first because of a weird, quiet, lingering "near-recession" that isn't called a recession for probably 6+ quarters.
* Because of the falling consumer confidence, the Housing Bubble soft-lands.
* The credit bubble goes on to fuel another speculative bubble. Probably not just one, but a few simultaneously. An easy guess is the stock market + other smaller, but rapidly inflating things like gold, commodities, maybe even a giant expansion of millions of "self-employed small businesses". Imagine everyone able to get free money to start their own little company, work from home, and think they're going to sell it to some bigger company for 100X in a year or two.

Eventually all that ends in stagflation and a new Fed Chairman who surprisingly resembles the zombified corpse of Paul Adolph Volcker.

But really, isn't September a bit late for a rate hike? Wouldn't they just wait til after the November elections to do it? The Fed's move this time is obviously motivated partly by political pressure, wouldn't that pressure increase by September?

Conor,

Thanks. He did say that (actually 25% hike). But he wasn't invoking Fed Futures, but something including Economists consensus, which included a 20% easing sentiment.

Randy,

Thanks. I was looking for analysis on investment risk only.

I doubt highly there will be a rate hike in Sept. unless all hell is breaking lose due to some serious shock that sends gas to $5/gal in the Midwest.

Short of that, no hike for a while, if ever in the near future.

I concur. No hikes. Fed is done. The only interesting bet is when will the easing start.

The 'Contrarian Chronicles' by Bill Fleckenstein have argued for years that Fed is run on an "applause meter". Also on CNBC someone mentioned that the Fed futures have been extra-ordinarily consistent in predicting rate hikes over last 10-12 years.

Reminds me of a classic quote from a very old BBC series "Yes, Minister". The lead protagonist once exclaims,

"I am the leader of the people. I must follow them."

Ah....but what happens if the Bank of England and the EU raise rates? Won't the Fed have to follow?

Ah….but what happens if the Bank of England and the EU raise rates? Won’t the Fed have to follow?

I don't think the Fed will get caught off guard and have to react to the actions of foreign central banks. Seems like monetary policy is fairly well coordinated by the leading central banks. Unlike our political leadership, I think the fed has shown that they can work well with others.

Nobody wants to see a "disorderly" collapse of the carry trade, so I think the major players will work together to avoid it.

"I concur. No hikes. Fed is done. The only interesting bet is when will the easing start."

I hope not. The last thing this economy needs is more people sucked in the RE by a "now or never" interest rate. I suppose a small number of ARM people might wise up and go to a fixed rate, but I doubt that's even a possibility for the majority of the group.

astrid :

From now onwards, Fed will be desperately searching for reasons to lower the rates. If the data keeps pointing towards inflation, or US$ devaluation picks up speed they most likely will not dare to cut rates. Otherwise any lame reason will do.

It is extremely important to revitalize the economy before 2008 elections, don't you think ? Coincidentally the ARM resets will also increase from 2007 end onwards. Many people bought in 2004 with 3/1 ARM.

I am just being realistic.

SiBA,

Yeah, I know. The power of short term thinking, it's always about getting past that next election hump.

I don't think revitalization is possible. The die is cast and it's now all a matter of friction and velocity of fall.

It is extremely important to revitalize the economy before 2008 elections, don’t you think ? Coincidentally the ARM resets will also increase from 2007 end onwards. Many people bought in 2004 with 3/1 ARM.

Should be very interesting. It is virtually impossible to predict future interest rates and currency fluctuations, IMO, especially when you project more than a few months into the future... still, it's fun to guess.

If the Fed keeps rates low, or lowers them even more, then I predict a steepening of the yield curve as foreign investors demand a larger premium on long bonds. But usually a recession keeps rates low, so that would seem to cut against my argument. This is too hard to figure out. My head hurts.

A 1/4 point drop isn’t going to mean much when you financed the house at 3% and the market is now down to 5%. It’s still more than you bargained for, especially if you took the lower rate to squeeze into a house you couldn’t otherwise afford.

People were getting 3/1 ARMs when the fed funds rate was at 1% (the rate on the ARM was probably in the 4-4.5 range). With fed funds at 5%, those adjustables are going to go to 7.5 or 8%. Not to mention all the teaser rates which will be expiring soon...

The point I was really trying to make is that it would take many fed cuts to bring the rates down to the level they were when all the ARM’s were being snapped up. One or two cuts wouldn’t stop the foreclosures.

Agreed. Even if they went to 0% fed funds, it might not help (eg: Japan). Should be interesting.

SQT,

That nothing can stop the bust that is well underway is a foregone conclusion to me as well. Again the only interesting topic is how fast/slow and how hard/soft.

The Fed behaviour is an independent topic to some extent. Their actions will not help homedebtors, but that doesn't mean they will not hurt us. I am more worried about their effect on me and my savings. I don't mind if I don't own a home in next 5 years, but I would hate to be in/out of jobs with pathetic salary and high inflation. Being "less worse" than a FB would be little consolation.

It doesn't matter if the cuts will actually do anything good for the economy. Fed "needs" to do them to show that they are trying. I am stealing lines from Bill F. here. "Fed wants to be loved".

We are in for a long, slow downturn that neither us nor homedebtors will like.

"Their actions will not help homedebtors, but that doesn’t mean they will not hurt us. I am more worried about their effect on me and my savings."

Exactly, that sums up the way I am feeling right now.

“Their actions will not help homedebtors, but that doesn’t mean they will not hurt us. I am more worried about their effect on me and my savings.”

Exactly, that sums up the way I am feeling right now.

In fact, if hyper-inflation is coming, the debtors will have their relative debt burden eroded by inflation, while savers will have their savings eroded. Sucks to be us.

skibum,

Only if you keep all your money locked up in bonds and money markets. Otherwise, a short period of hyper-inflation can provide someone with cash on hand a lot of opportunities - buying high yielding long term bonds, buying commodities, loan sharking...

I believe that the Fed went too far in hiking the rates, and they did so only to placate the multitude who fail to understand the lag times between monetary policy changes and its effect on GDP. By this time next year the target Fed Funds rate will be around 4% and falling. They will then go too low again as well.

Of course, it is difficult to judge the Fed without knowing what would have happened if a different policy course had been followed. But I think that the Fed always overreacts. Whatever the “right” policy is, they will do too much of it. This in turn requires them to be heavy with the antidote to their preceding mistake.

The huge liquidity move in 2001 through 2004 was excessive. And to the extent that it was excessive and lasted too long it was damaging. I think they should never have gone below 2%, and 2% should have been a six to 12 month affair with rates coming back up by the end of 2002. Instead they went lower (to 1%) in 2003 and stayed there until mid 2004. So the pot boiled over.

If only they would have the patience to wait for their medicine to take hold before upping the dose. They know that the lag time is about 18 months for peak effect on GDP and about nine months for the first real impact of their policy changes. And yet they get impatient and keep upping the dose until they overdose the patient.

Because of the lag efeect, the recent economic conditions are largely the result of last year's rate policy - when the target rate was still around 3%. Imagine how the economy will slow once the recent rate levels begin to kick in!

Now (at 5.25%) the Fed has already raised their target rate well above the natural equilibrium level. This is more than enough “medicine” to slow the economy, but it will take a while for the medicine to be digested. Any further increases will intensify the recession that will come soon (2007).

At 5.25% the overdose has alread been administered. Its going to get ugly before the end of 2007. It will take emergency action by January to even soften the decline. Look for urgent (panic) rate reductions during the first quarter of 2007. Either that or very high unemployment by 2008.

BTW inflation lags GDP by about six months. So expect inflation to rise even as the economy loses momentum.

Zephyr Says:

Now (at 5.25%) the Fed has already raised their target rate well above the natural equilibrium level.

I'm not sure I agree. My understanding is that 5-6% is well within historical range for a "neutral" or even slightly permissive monetary policy.

Zephyr :

What would be the reason Fed give to start cutting the rates ? Economic slowdown is one. But stagflation is a very real possibility. Are you suggesting that they will ignore inflation once again and cut rates ?

If that happens, US$ will devalue pretty fast. Ever since we reduced rates, Euro has appreciated tremendously against US$ in the same period. And so has Canadian $. If US$ becomes Peso, we will not be able to export our inflation to China. That will slow the economy down further.

If inflation persists, which I think will, then Fed will not be able to get away this time by reducing rates. Back to 4% in a year ? That's once bold prediction. It might happen.

But we will know in advance. This Fed has no brain of its own. It does what the market wants. Guessing Fed moves is not going to be difficult. I know there is such a speciality as 'Fed Watcher'. We don't need them no more. This spineless Fed is going to give in to "expectations". So watch the markets, Fed fund futures, and any one can be a great Fed Watcher.

If you go by the pre-Clinton CPI ("real" inflation that measures stuff other than beanie babies and Chinese-made lawn furniture), the Fed would need to hike rates above 7% just to hit neutral:

http://www.shadowstats.com/cgi-bin/sgs/

And, as the no-longer-officially-reported M3 shows, the Fed's easy-money spigot is still wide open:

http://www.nowandfutures.com/key_stats.html

But, hey, what do I know? I'm just a guy who has to --you know-- eat and use gas 'n electricty and buy health insurance n' stuff. You know --all that "volatile" crap the BLS either doesn't measure or hedonically adjusts out of existence.

here's something i just read on how they calculate CPI and inflation, at least in Oz -- the mean of 2 measures -- where they lop off the top 15% and bottom 15% of ranked price changes, for some reason...

Forget the headlines: RBA looks at core inflation

Here's another hint for the nowandfutures.com geniuses:

When you use Correlation Analysis in Excel, click the little boxes for Residuals and Probability Plot. In this case inspecting those would clearly show your regression is meaningless even if your rsq is off the chart.

They really do a disservice with their shit. When linking Here is our article on M3b, which details our work and notes the sources for the data. all they do is wave their hands (the entire content of that link is in my above comment). Where are the summary stats, data source assumptions, analyses of the error, residual plots, curve fitting, F-Test, etc.? I mean, c'mon, their formula has to be a multiple regression, as per their own description of how they computed it! Hell, I don't even see any analysis of the terms of the multiple regression showing they themselves aren't intercorrelated.

But hey, what do I know? I'm just a guy who takes the time to be skeptical of statistics, especially today's ever popular alchemical statistics.

SkiBum, The"historical" range for interest rates must be considered in the context of the historical environments. One must look at the historical level relative to inflation, GDP and the shape of the yield curve. For example 5-6% is a highly stimulative level when inflation is running higher than that (as it was during the years around 1980).

Historically the neutral and most common Fed funds target rate has been around 100 bps below the 10 year treasury bond rate. That would place the neutral rate at about 3.9% today. Generally, the FF rate has some tendency to on average be close to the growth rate of real GDP, which would suggest a rate of about 3-4% (and declining). Historically the FF rate has been about 100 bps above the CPI inflation rate, which would put it at about 4-5% right now. When everything is in balance all three of these metrics will point to about the same number.

The Fed forces the rate above the equilibrium level to cool inflation. You can see from the numbers above that setting the Federal Funds Target rate at 5.25% is in line with an effort to cool inflation but it is above the natural market equilibrium. The FOMC is in the market selling securities to push the market artificially to 5.25%. This mops up some of the liquidity which will cool inflation. Unfortunately it also cools the economy.

ajh, Long-term rates are determined in the free market (just like stock prices) and are by definition at the equilibrium level.

StuckinBA, The Fed will cut rates once it becomes apparent that the economy is in trouble. 4% by next summer is a very safe bet. Normally the Fed overshoots their rate policy (as they have again) and has to undo their damage before long. On average the Fed starts cutting within 6 months of the last increase, and cuts by about 100 bps by the anniversary of the peak rate level. So my forecast is that the Fed will do what they almost always do. Not so bold, really.

So when inflation is under control, and the economy is in a natural balance, and interest rates are in their natural equilibrium, THEN you will have the Fed Funds rate floating naturally at about 100bps above inflation, about equal to real GDP growth, and about 100bps below the 10 treasury bond rate.

Of course, we rarely have all of these things right at the same time, and in an effort to fix whichever thing is most out of balance the Fed is constantly manipulating the overnight interest rates to influence the economy.

During most of the last 30 years inflation has been abnormally high. So the Fed Funds rate has also been abnormally high during most of those years. Of course it was abnormally low during all of 2002 through 2004.

Zephyr Says:

During most of the last 30 years inflation has been abnormally high. So the Fed Funds rate has also been abnormally high during most of those years. Of course it was abnormally low during all of 2002 through 2004.

However, the Fed during the AG and BB eras seemed to have done a great job of obscuring the true rate of inflation from its decision making...

Inflation measures are just proxies for estimating what is really going on. Every method has its shortcomings. I personnally like the trimmed mean method best. But it is not perfect.

The current methods that use rent equivilence are more accurate than the old methods because it relates to the ongoing cost of ownership or renting rather than the asset value (The real cost of living in a house is the ongoing expense or rent - not the asset price of the house or the value you could sell it for). However, this tends to create a lag effect in the measurement of housing cost.

The old method overstated inflation, and also overstated the changes in inflation. If we were still using the old method for measuring inflation the current housing bubble would not look like such a big deal after adjusting for inflation.