Some of the commentary regarding inflation and deflation misses the point.? We are presently faced with both rising consumer price inflation and asset deflation.? Not a fun combination, to say the least.? It puts the FOMC into a real box.? To borrow an analogy from the Bible, Greenspan ate sour grapes, and Bernanke’s teeth are set on edge.

So what does the FOMC do in such a situation?? We don’t have that much history to work with, but during the ’70s, the FOMC generally loosened.? Fixed income portfolios should tilt toward shorter duration, even though you are losing income, and away from the dollar.? It is probably still too early to begin taking a lot of additional credit risk, but the bet is getting more attractive by the day.

Now, there are a number of commentators that can’t wait one week, and say the FOMC should act now.? The economy is not like someone that you have to take to the emergency ward; one week makes little difference, and the FOMC will do better work if they are meeting each other face-to-face under normal meeting conditions, than over a conference call.

Given the present equity market distress, should we assume that the FOMC will do more than 50 basis points in January? Had you asked me last week, I would have said “no.”? The political pressure is a lot higher now, so I would say yes, they will do more.? It won’t help the areas under credit stress, but it will make it look like they are serious about “fixing the economy.”

We could see a move of either 75 or 100 basis points.? I debate internally how good Fed funds futures are in abnormal environments like this.? Under Greenspan, I sometimes felt that monetary policy had been privatized, and whatever the futures market said, the FOMC would do that.? I don’t know if Bernanke has the same faith that futures traders know what the right monetary policy is.? If I were a Fed Governor, I certainly would not have that confidence.? Once the yield curve gets to a certain slope, the recovery will come in time.? Making the curve steeper won’t make it any faster.

People are impatient, and their complaining causes the FOMC to overshoot on policy decisions.? The lag that monetary policy has is significant, and the FOMC in recent years has made it even slower through their policies of incrementalism.

There are several possibilities here for the FOMC action:

1. They hold firm, and don’t lower much (50 bp), because price inflation is a concern.
2. They take the judgment of the futures traders, and move a full 100 bp.? Or, they conclude that asset deflation is a bigger risk, and decide to make a bold statement.? After all, isn’t Bernanke the guy who never wants to see the Great Depression recur, and loose monetary policy can prevent that?? (I don’t think that’s right, but…)
3. They split the difference, make bows to both camps in their language, and do a 75 bp cut.

The last of those seems most likely to me.? I have said in the past that the FOMC is:

• Being politically forced to loosen more than they would like, and
• Dragging their heels in the process.

That’s why I think we end up on the low end of where Fed funds futures will likely point tomorrow.? 75 basis points does not trip off the tongue, but will be a compromise position in the minds of Federal Reserve Governors who are puzzled at the present situation.? Because of political pressure, they know that they have to move big, but consumer price inflation will make them less aggressive.

Give the Fed some credit. Not literally, of course. Isn’t it their job to give us credit?

I haven’t talked a lot about Fed policy in a while, so I thought it was time to do an update. Five months have passed since my 3% sometime in 2008 call was made, and now it is becoming the received orthodoxy. That’s why I have to ask what is wrong with it, or better, what is the next phase beyond it?

Truly, I don’t know for sure, but I will offer out my thinking process. We are seeing rising unemployment and inflation at the same time. The bond market is rallying, anticipating falling Fed funds rates, but not forecasting rising inflation rates. (Buy TIPs!) In the spirit of watch what they do not what they say, let’s review the relevant Fed data.

• Effective fed funds have averaged 4.01% since the last Fed meeting. Sloppy on the low side. I believe intentionally so.
• Still no permanent injection of liquidity since 5/3/07. This Fed likes unorthodox measures.
• The Fed has increased the size of the TAF auctions by 50%, to $30 Billion on 1/14, and 1/28.
• Since 8/8/07, my M3 proxy has run 8.4% not annualized, followed by MZM at 6.2%. M2 and the monetary base are anemic at 2.6% increases.
• Ergo, the Fed is relying on the willingness of the banks to extend credit for their loosening of the money supply, not their expansion of the monetary base.
• The forward curve has a sub-3% fed funds rate in 2008.
• Finally, Fed funds futures and options favor a 50 bp cut in late January.

We are in a period of asset deflation and consumer price inflation, so this is a difficult period to negotiate through. You can listen to facile comments from PIMCO; everyone is focused on economic weakness, and few are focused on rising inflation.

I think we get to a 3% Fed funds rate, but we don’t get much below it, because by that time, a 3% Fed funds rate will imply a negative real interest rate on the short end. Congress will have an implied inflationary bias, because the complaints will come more from asset deflation. They will kick nudge the Fed that way to the extent that they can.

The TED spread is not as wide as it once was, but it is still in a historically high range. Anything above 60 basis points implies stress. To reduce this the Fed has set up an auction facility, called the TAF. The TAF has been expanded, which allows for a greater variety of securities to be lent against. That’s the real novelty of the TAF. Not new liquidity but new collateral. That said, even the discount window is getting greater use. As a result, the Commercial Paper market is showing some life, even for asset backed commercial paper.

So, liquidity is increasing on the short end, to the point where a 1/4% cut in Fed funds has for practical purposes already happened. A formal 1/4% cut at the next FOMC meeting would do little except ratify what has already been done. Now there is weakness in the job market, and the PMI is signaling some weakness as well. The yield curve has moved down, particularly on the short end, to reflect expectations of more cuts from the Fed.

But TIPS yields are quiet, at least for now, and viewing the Fed as quasi-politicians, whose main goal in life is to avoid political pain, the path of least resistance is to loosen policy further. Fed funds futures and options are indicating the most likely outcome in on January 30th is a 50 basis point loosening. Ordinarily, because of the “gradualist” culture that has built up inside the Fed, I am reluctant to argue for loosenings other than 25 basis points. I think at this point, I have to argue for 50 basis points, but with the usual squishy language that pays heed to all potential threats, effectively saying, “But no more after this! Conditions are balanced!” We know better, though. The only real question is when rising consumer price inflation or a deteriorating Dollar (think of 1986) will be a sufficient counterweight to economic weakness.

The US Dollar is weak here, and that reflects the judgment of many actors as to the value of what they get paid back will be. My guess is that foreign investors sense that inflation is higher in the US than is stated in the Government’s statistics. Too many dollar claims (internal and external) chasing too few goods that they want to buy. What will dollar-denominated bonds be worth at maturity? (Judging by current yields, quite valuable for now.) And will the US Government allow significant US companies to be owned by the Chinese, or by Arabs? How free market is the US really? Will foreign governments stop policies that disfavor the purchase of US goods? Perhaps once they import enough inflation, they will.

With gold, crude oil, and a host of agricultural prices high, and with structural reasons for them to remain high, the FOMC won’t feel too happy as they cut rates. But cut they will, and then we get to see where the excess liquidity flows. Some will bail out banks, which will invest in safe instruments in areas of the economy not under threat. Loans in or near default will not be affected. Well, more on that later. Tonight’s post will be on credit issues.

In closing, a return to the problem that I posed at the beginning: So what’s wrong with the 3% Fed funds forecast, or better, what is the next phase beyond it? It could go several ways:

1. Rising price inflation and a deteriorating dollar lead to an end to the cycle, and the Fed funds rate either stops falling, or has to rise to squeeze out inflation.
2. Continuing asset deflation, and declining but still positive economic growth (as the government measures it) leads the Fed to continue to loosen, or stand pat in the face of rising consumer price inflation.
3. Liquidity difficulties in the banking system morph into solvency difficulties, leading pseudo-M3 and credit to contract (after all the banks are doing the heavy lifting here, not the Fed) and the Fed starts to loosen aggressively.
4. We get a “bolt for the blue” leading to something not currently predictable, but which leaves policymakers in a bind.
5. We muddle along, get to something near a 3% Fed funds rate, and continue to muddle (think of 1992-1993).

Personally, I favor scenario 2. And, for those that like to invest, TIPS are reasonably priced. Insurance against scenario 2 is inexpensive, and relatively high quality. But be wary, because particularly in a Presidential election year, there could be significant surprises (part of scenario 4).

Long VIPSX