We Already Know the FED is Dead Wrong. But in Which Direction?
The FOMC meeting minutes are released the month after the meeting so that the world can get some kind of glimpse into the inner thinking of the FED members. I always look forward to these releases as I tend to base my macro views at polar opposite to whatever the FED thinks is going to happen. For well over two years now the FED has been blind, deaf, and dumb to the housing bubble and then to the credit bust that followed. In a sense the minutes can serve as a type of indicator.
Today the December minutes were set loose and they were a bit more ominous in tone than usual. From the New York Times article:
In Fed’s Decision to Slash Rates, Fears of a Long Recession
By JACK HEALY
Published: January 6, 2009
As Federal Reserve officials met last month to confront the deepening recession, they worried that even a dramatic cut in interest rates and unprecedented new measures in monetary policy would not be enough to cauterize the country’s economic troubles quickly.
“Even with the additional use of nontraditional policies, the economic outlook would remain weak for a time and the downside risks to economic activity would be substantial,” the officials concluded, according to minutes from the most recent meeting of the Fed’s Open Market Committee, released Tuesday.
The details of the December meeting shed some light on the central bank’s mood as it made the unprecedented decision to cut interest rates to a range of zero to 0.25 percent from 1 percent, effectively lowering the cost of money to nearly nothing as they tried to kick-start credit markets and encourage borrowing.
“The overwhelming message gleaned from the minutes of the meeting is one of fear — fear of a deep recession, and fear of a debilitating deflationary spiral that would capsize a debt-laden economy,” Joshua Shapiro, chief United States economist at MFR, wrote in a note.
They said that economic contraction would continue through the first quarter of this year, but most predicted that the economy would begin to recover during the second half of the year, with help from a government stimulus plan.
Unable to cut interest rates below zero, Fed officials also discussed how they could address the financial crisis using balance-sheet measures, such as buying up billions in Treasury debt or securities backed by Fannie Mae and Freddie Mac.
“Many participants thought that the Federal Reserve should continue to consider whether expanding some of the existing facilities and creating new facilities could be helpful,” the Fed minutes say.
But as they met, Fed officials acknowledged that while a drastic decrease in interest rates could stimulate “aggregate demand and economic activity,” it also had potential downsides in the function of “certain financial markets and some financial institutions,” like money market funds.
“Most participants judged that the benefits in terms of support for the overall economy of federal funds rates close to, but slightly above, zero probably outweighed the adverse effects,” the Fed officials said, according to the minutes.
In summary the FED thinks that the economy will rebound in the second half of 2009, with 2010 looking better. The FED sees unemployment going up into the year 2010, but then coming back down as growth returns. The FED wants to expand their buying of securities in a Zero Interest Rate Policy environment. The FED sees risks of low rates to inflation and money market funds as acceptable ills to fix the economy.
Ok, so we already know that the FED is wrong already. Time after time this has proven to be correct. At this inflection point there are two possibilities to consider.
The FED is wrong and growth will strongly rebound sooner rather than later
Could it be that the eternal optimists at the FED are too gloomy in their forecast? With countless dollars awash in the system and bankrupt companies getting new leases on life, might things get heated up faster than expected? The US treasuries bubble is sure to pop and there may be an avalanche of cash into risky assets like stocks and real estate. As quickly as the US consumer has hit the brakes on spending, they will be ready, willing, and perhaps able to mash the gas if credit again becomes easy to get.
The FED is wrong and we are looking at the Great Depression 2.0
While the December minutes are somber in tone, one has to take away a healthy fear that the FED is both confused and out of options. Considering all the lending facilities already in place, the FED is looking to start others? With interest rates at 0%, buying other debt and the long bond may incrementally lessen short rates, but by how much really? While you will never see the word DEFLATION on any FED memo anywhere, they are concerned about a "low level of inflation" which means deflation anyway. All in all, the FED may be painting a rosy picture here as the US economy, along with the world's economies, plunge into something like The Great Depression version 2.0.
While you may think I automatically subscribe to the second scenario, I am actually torn. Without even an illusion of fiscal responsibility, the US government is still getting funding and getting it cheap. This cash will make it into the economy somehow. At some point the banks are going to be forced to gamble with this money and get into risky assets to try and make something happen. In this way spending and lending could reignite and we could have a sharp rally, at least for a while.
In the end though things must end up as they must. A huge bust in in the works, but it may now be delayed yet again. I think the FED and the Treasury have until June or July to make something happen. After the 6 month period of the new year if things are not getting better, they will get worse. Much worse.
So I would say the we are heading for a Great Depression 2.0. The only question is whether that happens in 2009, or is delayed until 2011 or so. We already know the FED is wrong, but this time it is not clear exactly how. This should make for an interesting year. It also presents a great trading opportunity as either result listed above is far from the consensus view.
Have a good night.