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Friday, November 09, 2007 11:38 AM


What's Really On the Fed's Mind?


Gary North had some interesting comments the other day in Bernanke Eats a Large Helping of Crow.

In reference to Long term capital Management Gary North quipped:

This time, the FED is not facing one lone company whose leveraged positions have gone south. The FED is facing an entire segment of the U.S. capital market, which soon may not be able to raise money to keep its CDO (collateralized debt obligation) projects officially solvent. As long as these projects are solvent, the banks don’t have to write off the loans.

The banks are in a situation eerily similar to the Japanese banks in 1992. They are sitting on top of visibly bad loans, but they are allowed by bank regulators to keep these bad loans on their books at face value. This lets them stay in the lending business.
For more on Long Term Capital Management as it pertains to today, please see Genius Fails Again.

Meanwhile, Is The Market Healing?

The Fed's Poole says the Market is Healing.
Experience certainly suggests that central bank rate reductions help spur the healing process.
My comments: Poole's statement is nonsense. Experience throughout history clearly show the Fed's interventions in the market is what creates bubbles. Now that the housing bubble that the Fed is largely responsible for is busted, the Fed is acting again with the same solution that created the bubble in the first place. This time, the Fed is going to be in trouble because no bigger bubble can possibly be blown.
One thing that happens is that cuts in the policy rate—the federal funds target rate in the United States—serve to reduce the absolute level of rates on riskier securities even though spreads may remain higher than before.

Another thing that happens as a consequence of central bank action is an improvement in confidence.
My comment: Does confidence look like its restored? Where? Obviously Poole has not look at credit default swaps lately.
Despite market volatility, Fed actions have demonstrated to market participants throughout the economy—those in non-financial firms as well as those in financial firms—that the Fed will not be an idle bystander.
My comment: Yes indeed. The Fed has created a moral hazard by always being available to bail out banks whenever they get in trouble. This sets up an environment where bets get riskier and riskier. Eventually a mess so big is created that it's impossible for the Fed to bail out the participants. This is where we are now.
Let me also offer a conjecture. A cut in the federal funds target rate changes the nature of near-term risks facing market participants who take positions in risky securities. I have emphasized that the willingness of market participants to take risks is essential to the healing process that restores normal trading in risky assets. When the Fed cuts its target for the federal funds rate, market participants know that the FOMC’s decision at its next meeting will be either to leave the rate unchanged or to cut further. Barring unusual circumstances, the FOMC would not consider a rate increase just after cutting its fed funds rate target.
My comment: Let me conjecture. You and the rest of the Fed have to be half scared out of your pants to be talking this way with the stock markets less than 10% off their all time highs. This talk about inflation and stock market volatility is not what's really on your mind is it?
Although I am unable to forecast the future course of the FOMC’s target for the federal funds rate, I am confident that normal market functioning will return to the financial markets. Recent weeks show clear progress. There could be setbacks along the way, but the inherent efficiency of U.S. financial markets will ultimately dominate the outcome.
My comment: As evidenced by credit default swaps and the market's reaction to the last rate cut, recent weeks have shown negative progress. Furthermore there is no inherent efficiency in a system of central bank price fixing.

For more on price fixing by the Fed please see Ron Paul: We Have A Subprime Economic System.

What's Really On the Fed's Mind?
  • If the Fed was worried about inflation they would not be cutting interest rates.
  • If the Fed's view was "balanced" they would not be cutting interest rates.
  • If the underlying economy was "solid" the Fed would not be cutting interest rates.
  • If the Fed was concerned about the dollar they would not be cutting rates.
Gary North nails it when he says “The banks are in a situation eerily similar to the Japanese banks in 1992. They are sitting on top of visibly bad loans, but they are allowed by bank regulators to keep these bad loans on their books at face value. This lets them stay in the lending business.

That is precisely what is happening with the Paulson sponsored Super-SIV bailout plan for Citigroup. Unfortunately for the Fed, that plan has so many holes in it that it is looking more like a Super Sieve than a Super-SIV. For more on this idea, please see Number 3 Super-SIV Now Super Sieve in Wednesdays "Five Things" from Professor Depew.

The Fed is very concerned about a massive debt deflation credit crunch that restricts the ability of banks to lend and inhibits consumers desires to spend. Talk is cheap. The Fed's actions prove what is on their minds.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
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