The Road from Here to Stagflation

Cramer again.  This time I disagree more, because he is talking about the Fed.  He has five views of the Fed that he hates.  Let me take them in order:

1) The Fed doesn’t matter — It depends.  In the short run, when the Fed loosens, healthy assets get stimulated, but damaged assets don’t.  In the intermediate run, companies get financing from healthy financials to reconcile dud assets that were misfinanced, but the process takes time, maybe a year or two.

2) The Fed is pushing on a string — Initially, it will look like that is true.  It almost always does. Things that are viewed as problems now will not be helped by the initial effects of Fed policy.

3) The economy won’t react to the Fed, no matter what — Cramer is right to dis this one.  The Fed will revive nominal growth after a year or two.  The hard question is how much comes from inflation, and how much comes from real growth.

4) The dollar collapses because of cuts — Here I disagree with Cramer.  The dollar will decline.  Interest rates are a more powerful factor than GDP growth in exchange rates, because financial transactions are larger than trade in goods by an order of magnitude.

5) The Fed doesn’t want to do anything and doesn’t have to do anything — Well, true on its face, but the Fed is a political creature.  It responds to market signals, and it has signaled that it wants to “solve this problem.”  Cramer is correct here.  The Fed will act; the only question is how much.

But ask yourself a different question. How could the Fed break the logjam in the commercial paper market, particularly ABCP?  I clipped a lot of articles on this.  There is a lot of CP maturing (maybe $140 billion) in the next week or so.  It is not the banks that are so much at risk, though some will have to collapse conduits and bring asset back onto their balance sheets, lowering capital ratios.   The non-banks are the ones getting smashed, and the banks may have modest exposure to their woes.  Information Arbitrage has it right when he says that this is a case of misfinancing assets.  (Hey, maybe the Fed could directly monetize ABCP by buying it instead of Treasury notes.  No, no, please don’t… 🙁 )

Now, how much will the FOMC cut rates?  Unusually modest for PIMCO, they call for 1% by 2008.  (They never met a rate cut that they didn’t like.)  Fed Governor Plosser suggests that they have other tools they can use, without cutting the Fed funds rate. The ever-smart Jim Griffin concludes that the main risk to the Fed at present is inaction, and I agree.  At a time like this, the FOMC must do something notable, or the political heat cranks up.  Then again, we can look at the Treasury bond market as a whole, and easily conclude that at least 1% of loosening is in the foreseeable future.  As Caroline Baum puts it, “The fact that the funds rate is hovering so far above the rest of the yield curve is the most obvious sign that policy is tight. Yet Fed officials seem determined to see evidence of it in the real economy before they relent.”

Four quick notes before I end:

  1. Remember that Fed funds futures are typically only good for predicting the next meeting, and nothing beyond that.
  2. There’s still a lot of subprime debt to be reconciled in money market funds.
  3. Central banks are supposed to help with illiquidity but not insolvency.  At the edges, this is not so clear.  Illiquidity can lead to insolvency if bank capital levels are inadequate.
  4. An excellent summary article on all of this from the Bank of International Settlements, the central bankers’ central bank.

My summary: the FOMC will cut in September, and because monetary policy works slowly, they will be politically forced into more cuts than they would like, until signs of rising inflation cuts off the cuts sometime in 2008-9.  The yield curve will be much wider then, and then the hard choices faced in the 1970s will reappear, along with the s-word: stagflation.  I hesitate to use the word, because it is so sensationalistic, but I feel that we are headed there, slowly but surely.