patrick.net

Of course, the big economic news of the day is Bendover Ben's speech in Jackson Hole. As I'm sure many of you have noticed, the markets have reacted favorably to it, which by implication suggests it is being interpreted as a signal for a rate cut. Now, this may be well and true, but I think the comments are being taken out of context. Here is the pertinent section of the speech:

The purpose of the discount window actions was to assure depositories of the ready availability of a backstop source of liquidity. Even if banks find that borrowing from the discount window is not immediately necessary, the knowledge that liquidity is available should help alleviate concerns about funding that might otherwise constrain depositories from extending credit or making markets.

The incoming data indicate that the economy continued to expand at a moderate pace into the summer, despite the sharp correction in the housing sector. However, in light of recent financial developments, economic data bearing on past months or quarters may be less useful than usual for our forecasts of economic activity and inflation. Consequently, we will pay particularly close attention to the timeliest indicators, as well as information gleaned from our business and banking contacts around the country. Inevitably, the uncertainty surrounding the outlook will be greater than normal, presenting a challenge to policymakers to manage the risks to their growth and price stability objectives. The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.

The sentence that the markets seem to be creaming over is how, "(t)he Federal Reserve stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets." Seems to me that in the context above, this doesn't necessarily mean a rate cut is a given. Ben seems to imply that the discount window is the preferred tool in this liquidity crisis, but the Fed Funds rate could be used if there are any "early" indications of impact on the broader economy. IE, Wall Street shouldn't expect a "Bernanke Put."

Maybe I'm being hopeful, but that seems reasonable to me. Alternatively, this is just lip service and indeed rate cuts galore are coming...

The Fed Funds rate has been artificially too low for a long time -- until recently. The normal position for the fed funds rate is about 100 bps or more below the 10 year treasury.

The normal position for all rates is to be higher as the duration is longer. Overnight is the shortest duration, and should have the lowest rate. The fact that the fed funds rate is higher than all the other rates on the yield curve makes it clear that it is being artificially pushed to be so high. If the rate were allowed to float freely in the market it would drop by at least 100 bps.

Precisely! What’s left to demolish?

DinOR,

There's still The Fortress!

Zephyr,
I think we discussed this before, but the "normal" calculus of using the 10y treasury as a benchmark comparison for the "normal" fed funds rate seems to me not applicable. The Fed itself has acknowledged "artificially" low long-term treasury yields due to foreign money parked in these securities. Perhaps this underlying cause doesn't matter in the end, but it seems that the Fed has at least taken it into account in determining what they think the rate should be.

The 10 year rate is a market-driven rate. The result of natural forces of supply and demand. The fed funds rate is manipulated by the fed to keep it artificially at the level they have decided upon.

The long bond raes are not artificially low. The current rate levels are the consequence of natural market forces that should be expected to put the rates at their current levels.

If the fed stopped manipulating the market, I would expect the overnight/fed funds rate to fall to 4.0% or lower, and the 10 year treasury would probably settle in around 4.5% to 4.75%.

This would be the natural level with the current economic conditions.

Of course treasury rates are market-driven, but my point (not clearly made) was that compared historically, the current situation is unusual in that "saver nations" have dumped tons of cash into long-term treasuries in a situation not seen previously.

The fed cannot keep the fed funds target at an artificially high (or low) level for very long without causing problems in the economy.

We all saw the bubble effects of an artificially low fed funds rate. We are beginning to see the efeects of an artificially high rate.

Throughout all of this manipulation of the short-term rates, the long rates have been relatively stable.

"There's still The Fortress!"

I stand corrected.

Fire when ready Gridley!

Zephyr,

I see your point. That's why it's so important to get "the cost of money" right. Well said.

The savers of the world look for safe places for their money. This is not new. What is new is WHO these savers are.

Yield inversions are also "natural forces of the market". Zephyr is correct as a static analysis. But as skibum pointed out, the market structure of Treasuries have changed quite significantly over the same period.

If the "natural" Fed target is 100bp below the 10yr Treasury in 1990, then it would need to be more like 250bp below the 10yr in 2007 in order to match the effect of nominal versus real interest rates vis-a-vis inflation. The US has progressively been *losing* nominal rate power as an effect of foreign capital flows.

This is the primary argument against just using a simple, automated or semi-automated, transparent Fed inflation target. Such a target would have to be infinitely complex and is probably impossible to achieve without simply resulting in nominal-rate gaming.

As to the Fed's overshooting, I still disagree. If "Zephyr" is smart enough to see the overshoot, so are the hundreds of brilliant economists, econometricists, and statisticians working for the Fed. They know quite well how long it takes for rate moves to work into the economy, and they know the nature of their own historical data better than any of us armchair policy wonks.

The only folks deluded enough to think they could do the job better are global macro hedge fund managers and autistic fools.

Zephyr,
True re: savers. Moving on, the other thing that's been irking me while following the latest developments is that everyone (talking heads, economists, etc etc) are pushing/expecting the Fed to lower its funds rate to avoid recession, as the "downside risks have increased substantially." Fair enough. Then these folks usually go on to say that a big part of the economy is the consumer. Fair enough. It may not be pretty, but yes, we are a nation of fat, lazy, SUV driving, McMansion-living consumers. Then they all invariably go on to say how the tight credit market and the tight mortgage market leads to lower refi's, less cash-out for consumers to spend.

This is where the argument pisses me off. So, it's now a foregone conclusion that cash-out refi's as a way to keep the economy going is a GOOD thing? Are economists really truly advocating for a return to those times? God help us all!

SFWoman,

I think the problem is that there are no real conservatives left in the republican party, and I'm also not that convinced that there have been for a long time. Real conservative *voters*, sure, but they seem to prefer voting for conservative rhetoric rather than realizing the true nature of the semi-fascist bandits that are really running the party, and turning the other way.

"Anything for a tax cut"

Randy H,
I think that the case-in-point is the fact that the Fed has yet to cut the Fed funds rate as Wall Street Titans have been begging for recently. The Fed sees "downside risks" present, but if they were to overreact, they risk moving when they didn't need to. I see BenB as consciously trying to make moves as slowly as possible. It's like a very slowly responsive, nonlinear and very complex feedback system, but there is only one feedback loop (two if you count the discount rate) that can be manipulated easily. So, you want to manipulate it only when you are fairly certain the effects will be necessary, and perhaps as importantly, predictable.

Randy, I agree that the Fed does have an army of experts and great resources to evaluate the markets and the economy(far more than I or anyone else could ever have). However, it does not follow that all those experts have the same opinion of what the best policy is. And the implemented policy need not be the technically correct policy, as politics do exist.

For all that resource they have sure been far from the mark as far as perfect policy is concerned.

I agree that changes in the yield curve are natural to the market. But the actions of the Fed unnaturally exacerbate those changes.

As far as being delusional in thinking we could do better than the fed, that has good logical basis given the resources of the fed. However, many people (including me) thoughtthat lowering the fed funds rate to 1% was a mistake at the time it was done. In fact, I thought 2% was too low. And whatever artificially low rate would have been best, it should have been used for only a few months. Instead we got the credit bubble. I am not embsarrassed to be among the many "fools" who thought they knew better than the fed back then. And we "fools" were right.

But, in the end, while I objected to the policies, there was no harm to me from it. This is because I knew what economic craziness would come of their moves and I made piles of mony betting on it.

Folks,

Should we blame Japan for world wide currency printing.

Japan has consistently followed Zero Interest Rate Policy (ZIRP)

http://en.wikipedia.org/wiki/Zero_interest_rate_policy

The zero interest rate policy (ZIRP) is a Keynesian macroeconomics scheme for economies exhibiting slow growth with a very low interest rate, such as contemporary Japan. The Keynesian (and neo-Keynesian) thesis is that these countries are in the so-called liquidity trap, an assessment with which neoclassical economics disagrees.

Under ZIRP, the central bank maintains a 0% nominal interest rate, and then maintains inflation of the currency to make the value of otherwise stable investments, such as real estate, rise over time. It is effectively a way of imposing a negative real interest rate.

For instance, if an investment earns 0% interest and there exists a 4% inflation rate, a house or commercial property will appreciate in value by 4% a year. This means that the return on the investment is calculated as if the interest rate is actually -4%.

The effect of a ZIRP policy is to encourage investment throughout the economy by making capital purchases more financially attractive. Whether ZIRP succeeds in achieving this goal is a matter of much debate.

Bush said the Federal Housing Administration, a government agency that provides mortgage insurance to borrowers through lenders in the private sector, would launch in coming days a program called FHA Secure. The program would let homeowners who have good credit histories but can't afford their current mortgage payments to refinance into mortgages insured by the FHA.

Bush also said the administration would launch a new foreclosure avoidance initiative to help homeowners figure out a way to refinance. He said Housing Secretary Alphonso Jackson and Treasury Secretary Henry Paulson would reach out to groups that offer foreclosure counseling and refinancing assistance for homeowners.

Bush is going to guarantee a bunch of people who got in over their head and can't refi, by using FHA loan programs. He is also going to modify the tax code, so that forgiven debt won't be counted as taxable income.

Bush has been the banner carrier for the Republican Party and the Conservative movement for over seven years now. It is amusing to watch all those who cheered his so loudly when he played "dress-up hero" in his flight suit abandon him now.

Jimbo said about Bush
"He is also going to modify the tax code, so that forgiven debt won’t be counted as taxable income."

The lack of a tax penalty will take away a big disadvantage of short sales. Buyers may then benefit from lower prices at the expense of the bank that made the original loan.

ZIRP can be very effective if applied to a country not subject to a liquidity trap. There is no reason to believe the US would suffer from the same liquidity trappings as Japan. The US reacts quite well to monetary inflation based growth -- we are a consumer society.

The problem with ZIRP in relation to US policy is that it is a draconian measure, to say the least. It effectively translates into a subversive default on US foreign debts, and a subversive subsidy for US exports. It also shifts even more US inflation oversees. The reaction of foreign debt holders will be to either eat it, or to fight back. Fighting back would cause US hyperinflation, except for two saving reasons that is all but impossible: 1) by fighting back they will suffer worse than we do simply due to their low percentage domestically derived GDPs; 2) the US won't hyperinflate because no country willingly hyperinflates, and all countries with credible, projectable military forces escape hyperinflation without exception.

ZIRP is a policy of renewed interest for me, in that the govt and central bank of Japan has mandated that the IR always be 0%, unlike other economies where it flaps around in the wind of the market a lot more. ZIRP seems highly interventionist to me, whereas other central banks are supposed to be reactive to market conditions, for better or for worse. This means therefore that interest rates in other industrialised countries can climb up to, say, the 17% we've seen in past decades, causing a lot of grief for mortgagors and businesses carrying overdrafts alike.

There were reasons for instating a ZIRP in the first place, to do with Japan's own economic crisis and asset bubble, and it has created a peculiar international carry trade in the yen which has woven itself into the market.

Monetary policy and macroeconomics aren't my particular strong suit, and ZIRP has been mentioned before, I think in its own thread, but I'm suddenly intrigued again due to the Oz opposition 'alternative govt' promising in an election year to 'keep interest rates low'. Historically neither side of politics has been keen to interfere with the setting of interest rates, to the detriment of mortgagors who buy at the top of a price bubble, if the Fed starts escalating interest rates to 'calm an overheated economy'.

(I have my own views on the limits of using one lever only, interest rates and the reserve, to attempt to 'manage' every single aspect of the economy at once, being housing, personal borrowing, business borrowing and investment, and so on.)

Any thoughts? Dare I start a thread?

I have lots of thoughts. We did have a thread on this a while back. It's too bad wordpress doesn't have a scroller of recent comments so we could just add to that thread, so as to not repeat all the same base arguments. The subject is very complex and writing level headed responses takes a lot of time and effort. I'm just too tired and heading into a holiday weekend to think much more about ZIRP.

as per http://patrick.net/wp/?p=213, authored by yourself.

I've just re-read it, and my feelings were similar at the micro level, that it would only encourage more investment in property and price inflation, and provide a field day for landlords, as interest rates are one of the hurdles to property investment. Low interest rates seem to have been a big factor in the bubble, along with liberalised credit products from lenders.

I think I'm just amazed at comments by both parties about the merits of 'keeping interest rates low' to keep voters onside, when in fact I and others argue low interest rates helped spark the bubble in the first place. I'm not sure whether the economists working for the parties are autistic, or whether they're being over-ridden, assuming they employ any, due to populist vote-grabbing. In the meantime, the Fed just pushed up interest rates 25 base points, and are tipped to do it again straight after the next election. Their economists obviously see things differently, and I am not sure what sort of changes the opposition expect to put in place to suddenly be able to promise to 'keep interest rates low', short of creating a centralised command economy to manage every other externality that might arise.

Easy money is always politically popular, both parties play that game. Personally, I think Greenspan did exactly the right thing, by saving us from a major recession in 2001 and that Bernanke is doing the right thing now, by trying to execute the fabled "soft landing."

Unfortunately, no one wants to use actual Keynesian stimulus anymore, which would have probably been more appropriate in 2001 and would not have led to an asset bubble. When you only have one lever (interest rates) everything looks like cause for an interest rate cut.

The fed did the right thing -- they just did too much of it.

Jimbo, I disagree. Zephyr is more on target, although saying the Fed did the right thing but too much of it more or less says they screwed up, at least partly.

I'm more old school. We need recessions once in a while. You need an impetus to clean out the system and clear out the dead weight once in a while.

Back in the day when we used to have an industrial base, it made sense that we might "need" a recession to clear out over capacity. But what does that mean in the context of a service economy? Too many software developers? Isn't that what happened in 2001-2002? Too many new homes chasing too few credit-worthy borrowers? That is what we are seeing now. Better financial engineering and better inventory control mean recessions are going to be shorter and less severe.

For those in tech during 2001, that was not a mild recession at all. I ended up out of work for six months, then got a job, only to be laid off in a big down sizing at the second place seven months later. I finally found another job three months later. And I was one of the survivors.

Most people I know who joined the party late, moved back to their home towns and left the field entirely. The only thing that kept me employed at all was my network, which I had built up since college.

Too many software developers?

In a word, yes. The good ones will remain employed, the bad ones will go back to serving coffee at Starbucks.

Perfect current example - so much of Web 2.0 is useless crap. A good recession will clear that out.

It will not require a recession for it to happen though, that is what I am saying. Why should there be an economy-wide recession, just to correct an imbalance in one sector?

Maybe the housecleaning happens faster that way, but I am not really convinced that this is better for the economy when it does. Eventually VCs will grow tired of throwing money after all the "me too" social networking sites, but remember, before Google, everyone thought that search was a tired and done sector.

If the NAR and NAHB want to fund a bailout, then I have no objections. I didn't know these organizations were in the business of giving money for bail outs, though.

Maybe you were mistakenly referring to the National Association of Retards and the National Association of Hemorrhaging Buyers?

Until I hear one address what is to be done about the CEO's of these comapnies/banks.... that were part of the lending that lead to this meltdown ...that taxpayers are now being saddled with....I have little respect for any. I hear a lot of posturing, but not ONE has mentioned these CEO's walking away with MILLIONS...MILLIONS...while we tax payers already struggling are left to pay for their mess...and they walk away with parachute packages worth MILLIONs....Only one..has refused to accept his windfall and sent the money and perks back to be used to cover the debt that his company is responsible for. UNTIL these politicians hold those responsible accountable...Do not think anythnig they say will matter to the American public..I don't care what grand plans they have...beyond it's money out of my pocket, and your pocket to cover the mess made by those who are walking away millionaires. Let's hear a candidate address that issue and what's to be done to hold them accountable..Like maybe NO bail out for any that accept the golden parachutes and leave them on their own to sink or swim. If you want the American public to pay for your mess then first take care of as much of the debt as you can yourself. Every Joe Schome that goes to Bankrupty court has to cover as much of the debt as he can and we're not talking multi millionaires here or Billionaires but average working class struggling Americans...They don't get to walk away scott free....

Will we ever hear a politician actually stand up and say..NO we wont bail you out...we wont offer a plan..we wont do anything until you help yourself out of this mess and cover as much as you can...SEE I have a huge problem with this...And no one ever mentions it...I wish someone with financial background would look into it and come up with the figures of how much overall these CEO's and Coporate officers are going to walk away with as the taxpayers are forced to bail out their mess...and will the bail out money be used for their golden parachute packges..Is that part of the deal? Where does that Money come from?

I've had enough political posturing and plans (that amount to basically nothing...beyond more money from taxpayers..) I want real answers to real concerns....and no more sound bytes or the same speeches over and over that say nothing...

Thanks to you Patrick as you seem to be the first person anywhere to even question Obama or his plans....He gets a free pass from the media..so I applaud your courage.