Special Favors from the Federal Reserve

I like writing about the Federal Reserve because I understand it well, but this is beginning to make me tired. Here goes:

  1. There are some who believe that the Fed will not cut rates soon. I half agree with them, because the Fed should not cut rates here. Let bad loans get their due punishment. That said, that ‘s not the way the Fed has acted for almost 80 years. Given that the Fed has to interact with politicians and businessmen, they are going to get a lot of negative feedback if they don’t loosen the fed funds rate. I general, the Fed caves to political pressure. This Fed is doing it now, but just in small steps, while they console themselves that they haven’t moved yet.
  2. On the surface, not much happened with the reduction in the discount rate. But the real story boils down to a willingness of the Fed to accept classes of securities that previously they would not. This includes ABCP. Beyond that, the Fed is allowing several large banks to lend beyond prior limits to their securities affiliates. This allows the banks to lever up more, and in relatively risky business. I am waiting to hear of charges of favoritism; failing that, of irresponsibility of the Fed in overseeing bank solvency of some of the largest banks.
  3. The actions that the Fed takes now will shape the next financial crisis. Where it loosens, leverage will flow to healthy areas that can absorb it until they become glutted as well.
  4. US T-bills have righted themselves, but i was surprised to see that Canadian T-bills went through a similar mishap. Oh well, they had ABCP also.
  5. SIVs are one issuer of ABCP, and many of them are doing badly now. I would not be too quick to rescue them, or be too optimistic about their ability to make good a maturity. The assets in the SIVs that have gone bad are not likely to turn around quickly. Next cycle, we will be more careful about what we lend against, until we commit the same error in a new way.

I hope the Fed’s actions so far will be enough, but I believe that they will have to do more.


  • dukeb says:

    General Comment: Excellent blog so far! I’ve been reading it every morning for a while now, and feel you are one of the best at supplying an array of links wrapped in focused, level-headed, fact-based, intelligently written opinion. Please keep up the great work. Thanks!

  • Achal says:

    Hi David,
    Love your postings. You are voice of sanity.
    I have been trolling around, looking for cheap stocks to buy. One name that caught my eye is YRCW. It looks cheap using TTM metrics. Without doing more work, it’s not obvious to me *why* it is so cheap. Could you point me to a good place to learn more about this name / industry. For instance, it would be a great learning experience to see how you went about analyzing this particular company.


  • RB says:

    Mechanical models show that there is a fair amount of higher core inflation at the core and headline baked into the cake for the next year — which is the Fed’s concern. Further, a recent Fed publication from the St.Louis Fed I think shows that they realize that excluding food and energy is not a good strategy, whether that influences policy in the future will probably be communicated. Eric Janszen at itulip has always believed that deflation was not a threat because of the Fed/politician’s psyche and so far there is nothing to dispute that.

  • rich t says:

    I think Jim Grant’s NYT piece has was unintentionally unclear on his position… he has generally called for rate cuts sooner rather than later and is quite cynical about the Fed’s “inflation fighting” credentials.

    I suspect that the “maybe he’s seeing the light” comment was intended to imply… “but probably not.”

  • James Dailey says:

    I am continuously baffled by the wide disparity in the definition of inflation. I think it is actually a pretty easy concept. There is demand and supply for credit and given a hard currency interest rates “regulate” that balance. It doesn’t prevent booms or busts because people will be people, but it does preserve the value of a currency over the long term.

    Fiat currency inevitably leads to excess credit creation. As long as people are desiring ever-more amounts of credit, this is inflationary. However, the obsession of US economists to label “inflation” soley as “consumer inflation” is very dangerous. Credit can be created and demanded, but the government cannot control where it is “spent”. Rapid credit creation can contribute to asset bubbles – also a symptom of inflation. Whether it is consumer prices or asset prices, they are simply the symptom of inflation, which at its root is a the combination of demand for credit with excessive credit creation.

    The last 5 years have been fascinating because it is quite clear that the central banks have largely lost control of inflation. Credit has been created at an explosive rate via non-regulated financial entities and off balance sheet operations. Derivatives have been a primary mechanism. The recent rumblings in the credit markets suggest that demand and non-gov’t creation may have reached a tipping point. Credit is now being taken away and destroyed. Left to itself this is the inevitable result of massive credit inflation. The Fed and congress may try to stop a deflationary credit contraction, but unless they can re-ignite the collective desire by people and institutions to demand more credit, just offering it and making it easy to obtain is not enough (see Japan). Either a deflationary credit crunch will develop with assets being liquidated or the gov’t gets too aggressive with trying to “encourage” credit demand and the dollar drops – which is hyperinflationary.

    The timing of all this is uncertain for sure, but no nation in the history of the world has successfully navigated out from under such a massive credit inflation. Talking about ridiculous academic notions of “core inflation” or incredibly tortured price indexes is just aiding and abetting the movement towards these outcomes. All of this in my opinion of course!

  • rich t says:

    Well said James! The way I think of it is: money can lose purchasing power against anything that money can buy — including financial assets, and certainly not just stuff in the CPI.

    I happen to think that the Fed will do what it has to to keep deflation at bay and, per Bennie’s famous 2002 speech, that they have the tools to do so. They can always monetize… credit can contract, but once printed, money sticks around.

    Anyway, I am also baffled by how ill-understood inflation seems to be, and I am on the same page as you. (As is Jim Grant, just to circle back to my first comment).

  • AllanF says:

    Hello James,

    To add to your comment about just offering credit is not enough if no one wants it, that was also the case in the Great Depression. I’ve seen money growth charts for the years leading up to, during, and after the Depression. They are amazing. I also remember seeing a show on the History channel on coin mints in which they made a passing mention about the amount of coins that were stock-piled during the Depression because no banks could use them.

    I think when 50% of the population has just lost 80% of their wealth, no one has any stomach for risk. They are disgusted by the whole thought of it. Just putting food on the table is all they are concerned with.

    I also think that is why Depressions are so scarey to central banks. They essentially have lost control. Making credit available when no one wants it is useless. In today’s global world it just creates a carry trade to goose other economies (Japan). Dropping currency from helicopters when no one wants to invest won’t grow the economy either. It just creates hyper-inflation.

    But before you go betting on carry-trades or hyper-inflation in the US, I think you have to consider a certain cultural component. Is the populace of the US capable of being either risk-disgusted or asset-satiated? I don’t know. We’ve been skimming the most motivated-to-get-ahead individuals in the world for some 100 years. IMO, that has to matter for something.


  • James Dailey says:

    Hello Allan,

    One demographic force that does suggest that increased risk aversion is possible/likely is the titanic sized bulge of baby boomers fast approaching what they believe is a God given right to retirement age at 62-65. Most are not prepared financially and those who have some assets are likely to get VERY risk averse at the first signs fo strain. Anecdotally, much of my client base is comprised of this demo and they have extremely low tolerance for downside volatility. Now that most boomer’s largest asset is deflating, I doubt that the impulse to take risk will return quickly.

    I am not predicting hyperinflation – just pointing out what the likely market realities would be if/when the government tries to respond to the inevitable credit contraction.

  • AllanF says:

    James, thanks for mentioning that angle. I’ve often thought Japan’s long recession is due to their demographics. I’ve figured the US’s demographics portend inflation. The only feasible way to keep Social Security and Medicare from eating up the rest of the budget is to inflate away the COLA’s.

    Yeah, I know COLA’s are supposed to offset inflation, but what if they don’t? What can one do?

  • James Dailey says:

    Allan F, I think your comment is spot on but I disagree with your conclusion! The Japan analogy is perfect – I just think you draw the wrong lesson. The Japanese gov’t has gone to EXTREME measures using monetary and fiscal policy to try and stoke domestic consumption and reduce domestic savings….with little success. My entire point is that the government cannot control the aggregate psychology of millions of consumers/savers/investors. The major difference I see between Japan and the US is that the Japanese debt was largely financed domestically, while we are dependent on the kindness of strangers. If we try to inflate and foreign gov’t and/or investors reject an inflated dollar or choke on it, then our rates could spike and the dollar could collapse – even as risk appetite is very low in the aggregate.

  • AllanF says:

    Fair enough James. Thanks very much for the excellent discussion.

    My hesitation with Japan being the perfect analogy is 1) we aren’t as old as Japan 2) our culture is far more acceptable of risk and second tries. But I agree the lesson is as you state: govt cannot overcome the psychology of millions.

    Regarding your experience with the 62-65 y.o. demographic and their down-side risk aversion, over at Calculated Risk, this weekend there was a post about one of the investors in the Bear-Stearns MBS hedge funds (they had been opened to investors with $250k to invest, down from their original $1M). He thought 15-18 months of steady 1% gains were a sign of low-risk. Obviously down-side volatility was his overriding concern.