Part 1 of this unintended series came two weeks ago, when the FOMC was resolute that there were no problems in the markets that could potentially har,m the economy. Then, one week later, after the FOMC showed that it was willing to toy around with temporary liquidity, I knew that I had to change my FOMC opinion, and rapidly. It’s akin to a situation where someone protests their virtue, but cheats a little; at that point the question become how far he will go. With the FOMC, a small change in temporary liquidity would not convince the banks of the seriousness of the FOMC, and would engender no additional confidence. Given that the FOMC showed that it wanted to fix the problem, it had to ask the question, “What’s the minimum we can do to make the problem go away?” Or at least, get the problem away from the Fed’s door?
Here’s the problem, though. In a credit crisis, there is variation in how much trouble each firm is in. When the FOMC provides liquidity, it stimulates healthy firms and provides no stimulus at all to firms that will die, because the credit spreads to those firms are too wide, assuming that anyone will lend at all to them. It’s the marginal firms that benefit the most from a change in Fed policy to loosening. The earlier the FOMC acts in a credit crisis, the fewer marginal firms go under. The lowering of short term rates convinces lenders that the marginal firms can be refinanced at lower rates, and after some fitful action, the weak but not dead survive (and their stocks fly). Also, the earlier the FOMC acts, the more moral hazard it creates, because the markets know that the FOMC will rescue them, and so they take risk to excess.
Now, a lowering of the discount rate, and encouragement to use it, does several things. Unlike Fed funds, lower quality collateral can be lent against. The encouragement to borrow reduces the stigma; it tells the bankers that the regulators won’t cast a jaundiced eye on borrowing. (Previously bankers would worry about that.) That will to some degree reliquefy the market for riskier assets, but given that credit spreads have blown out for a wide variety of Asset-, Residential Mortgage-, and Commercial Mortgage-Backed securities, how much will 1/2% on the discount rate do? My guess: not much.
Now, the change in the bias does more. It shows that the FOMC will start permanently loosening Fed funds, probably at the September meeting, unless conditions worsen soon. They still haven’t injected any permanent liquidity yet, aside from what little the discount window will bring, so some marginal firms will continue to deteriorate until then.
That they did a rare intermeeting announcement highlights the FOMC’s commitment to reliquefying the economy. They are into the game with both feet, betting their socks and underwear. 😉
Here’s my projection, then. There are still a lot of hedge funds that are presently alive that will die in the next six months. Housing prices will continue to go down, dragging down hedge funds and financial institutions with overcommitments to alt-A loans and home equity loans. There will be howls of pain from them and their lenders, which will goad the FOMC into loosening more than is currently believed. I see a 3% Fed funds target rate at some point in 2008, barring a US Dollar crisis (possible), or inflation (however well-massaged) convincingly exceeding 3%.
A few final points before I end. The communication of Governor Poole certainly could have been handled better. We got a real whipsaw in the markets as a result. I have mentioned in the past that he is often out of step on the hawkish side; this was another example. But for the repudiation to come so quickly was astounding. As it was, the New York (read, Wall Street) and San Francisco (read, Countrywide) Regional Federal Reserve Banks sponsored the actions, and all but Poole’s district, St. Louis, went along, and asked for cuts in the discount rate. St. Louis, caught off guard, belatedly asks for the same thing but starting Monday, not today.
Now, do I favor this from a public policy standpoint? No. Let the system purge, that risk once again gets respected. You can hear the indignation on some market participants, like my friend Cody Willard, and Allan Sloan at Fortune, who wonder why we bail out extreme risk takers. (My take, the extreme risk takers will still get purged, but the marginal ones won’t.) Others, like Larry Kudlow, and perhaps Rich Karlgaard at Forbes, wring their hands over moral hazard, but say it has to be done this time to preserve the economy. Then you have clever realpolitik coming from Caroline Baum of Bloomberg (written before today’s moves), who says that Bernanke will do all he can to prevent another Depression. Beyond that, we get booyahs from Cramer, PIMCO, and a few others.
So here we are, two weeks later. The stock market is lower. Yields on the highest quality debt is lower, and low quality yields are higher. Option volatilities for almost all asset classes are much higher. The separation of firms viewed as marginal now will continue to get separated into two piles, dead and survived. In the last FOMC loosening cycle it took three years to get there, from March of 2000 to the spring of 2003, when the high yield market realized the crisis was past. And housing was flying. Amazing what reliquefication can do for a healthy sector, and creating the next bubble too.
This won’t be over in a short amount of time. Look for quality firms that can benefit from lower funding costs, and toss out firms where additional financing is needed, but won’t be available because of high credit spreads, devalued collateral, etc. Buy some TIPS too, and maybe some yen [FXY] and swiss francs [FXF]. Dollar purchasing power will continue its decline.