Musings on the Fed and Yesterday’s Article

From Tuesday’s Columnist Conversation over at

David Merkel
Thinking About the Fed
11/20/2007 1:51 PM EST

One of my maxims of the Fed is that it is better to watch what they do, and pay less attention to what they say. The markets are saying that they expect Fed funds at 3% sometime in 2008. The Fed governors see that also, and are being dragged there, kicking and screaming. They don’t want to do it; there is real risk to the US Dollar, and there are inflation risks as well. As they measure it, the economy is growing adequately, and labor employment is fairly full. But as Cramer and others point out, the financial system is under stress, manifesting most sharply in mortgage lenders and insurers. Secondary stress is in the investment banks and financial guarantors.

But what exactly has the Fed done so far? Most of the monetary easing has not come through growth in the monetary base, but from continued relaxation of reserve requirements. Given that the Fed is loosening, I would have expected a permanent injection of liquidity by now. As it is, the last one was May 3rd, when there was no hint of the loosenings coming.

So what then for future FOMC policy? The banks are increasingly incapable of levering up more. The monetary base will have to grow. With the Treasury-Eurodollar spread at over 170 basis points, the big banks don’t trust each other. Again, this measure points to 3.00-3.25% Fed funds sometime in 2008.

I see them getting dragged to cuts, kicking and screaming, until a combination of inflation and the dollar force them to change. Then the real fun begins.

Fed minutes out soon. Watch them make a fool out of me.

Okay, the FOMC minutes did not make a fool out of me.  Neither did the market action.  I’m in the weird spot of thinking that nominal economic activity is higher than expected, on both an inflation and real GDP basis.  I don’t like the mortgage and depositary financial sectors at present, two areas that are dear to the FOMC.  That’s where I stand.

One reader asked, what do you mean by, “Then the real fun begins.”?  Maybe I have to do a book review on James Grant’s, “The Trouble with Prosperity.”  James Grant is very often correct, but usually way too early, which is why it is hard to make money off of his insights.  The “real fun” is watching FOMC policymakers squirm as they balance off costs of inflation and economic growth on the negative side, as it was in the late 70s and early 80s.  It is also the fun of watching policymakers at the Treasury Department squirm as they realize that the the fiscal wind is in their face and not at their backs anymore, as the demographic winds spin 180 degrees.

Other readers e-mailed, asking the practical question of how to invest in such an environment.  First, don’t overdo it.  Invest for a normal market scenario, and then tweak it to add more short bonds, TIPS, Commodities, Foreign bonds, and stocks with good inflation pass-through.

I got a few questions asking me to justify my bearish view on the US Dollar.  On, a purchasing power parity basis, the US Dollar is fairly valued now.  (What goods can the Dollar buy versus other currencies?) Unfortunately, currencies react more to forward covered interest parity in the short run. (What will I be able to earn by investing my money in dollar denominated debt, instead of another currency?)  Low intermediate term interest rates in the US portend bad returns from investing in US Dollar denominated debt, so the US Dollar declines.  The rest of the world seems to be bracing for more inflation and more growth.  Because US policy is headed the other way, the US Dollar is weakening.

As for my longer-run negative view on US Bonds, US government policies are designed to undermine bonds.  They have made more future promises than they can keep.  Who will they renege on their promises?  Bond investors are the easiest target; they don’t vote in large numbers.  It will be harder to turn their backs to those receiving social insurance payments, at least in nominal terms.  They have a lot of votes.

That’s all for now.  More tomorrow.