Should the FOMC Statement have been a Surprise?

Here’s the quick answer: no.  The Fed Statement was what I expected.  Read Dr. Jeff’s pieces on the reaction to the Statement; he hits the nail on the head.  No one should have been surprised at 25 bps, no differential change in the discount rate, and an evenhanded statement.  Real GDP is still growing, unemployment is low, and inflation is low also (pardon any differences on measurement issues).

There are too many people who are little better than cheerleaders for the equity markets, and think that the Fed should cater its policy for the good of public equity shareholders.  Forget what you think the FOMC should do.  I gave that up seven years ago, and it was amazing how much better my FOMC forecasting became.

The Fed only has three functions:

  • Keep inflation low (as they measure it)
  • Keep labor unemployment low (as they measure it)
  • Protect the security of the depositary financial system, particularly that which is affiliated with the Federal Reserve.

Three functions the Fed does not have:

  • The exchange value of the dollar, except as it affects inflation
  • Affecting the value of the bond market (though they occasionally mess around there trying to affect the shape of the yield curve)
  • Preserving the value of the stock market.

At some level of fall in the stock market, the Fed does care, but only because it affects soundness of the banking system and labor unemployment.  While the stock market is within 10% of record highs, it does not figure into the calculations of the FOMC.  Maybe at a decline of 30% it does matter to them.

Now, this doesn’t mean that the FOMC isn’t going to eventually lower the Fed funds rate to 3% at some point in 2008.  I believe they will still do that, largely because of the effect that falling housing prices will have on the credit of the residential mortgage market, and not just Subprime, but Alt-A, and Prime loans as well.

The thing is, the FOMC is off on a fool’s errand.  The cheap credit that they inject will overstimulate healthy assets, perhaps encouraging healthy US firms to level up using short-term finance, and buy back stock.  It’s one of the few areas of strength left.  What else could absorb the incremental credit?  The US government?  Maybe.

Cheap credit can’t reflate a sector in fundamental oversupply, like residential housing, unless the FOMC were willing to let inflation rip, perhaps leading the value of residential housing to rise, as it did in the ‘70s.  More likely though, is that commodities that are in short supply globally would rise, like coal, steel, oil, gold, rare minerals, etc., and only after a while, would housing prices rise, as nominal incomes become large enough, and household formation great enough for the excess supply to disappear.

But inflation would lead mortgage rates to rise, which would cut against the ability to afford housing.  So, let this be a takeaway.  The FOMC is using their powers for other than there stated purposes, but grudgingly.  Their actions may preserve some marginal lenders, but will be inadequate to reflate housing, particularly in the short run.

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Now, I wrote the above while on a plane heading from LA to Baltimore, so I only found out about the Fed’s announcement about their term loan facility when I got home this evening.  Not to be a perpetual pessimist, but I think this idea is more show than substance.  The Fed can discontinue this program after two months.  The Fed has not done a permanent injection of liquidity since May 3rd, and growth in the monetary base is anemic.  All of the growth in broader monetary aggregates is coming from the banks stretching their balance sheets.

This may work in the short run to lower the TED spread, but unless the Fed makes a commitment that they will keep doing this until the market sees things their way, it will not have a major effect on the markets.  I don’t care how many different types of collateral they might take; if they won’t guarantee to take that collateral on favorable terms for a long time, it will amount to nothing by mid-2008.  For a clue to the market’s view, watch the change in 1-month LIBOR versus 12-month LIBOR.  True credibility will be measured by the change in the yield on 12-month LIBOR.