Fed Cuts Rates Again

On the back of news that GDP growth in the 4th Quarter of 2007 was a less than expected 0.6%, the Federal Open Market Committee (FOMC) cut rates for the second time in as many weeks this afternoon, lowering the benchmark federal funds rate to 3% and the discount rate to 3.5%. The Fed has now lowered rates 125 basis points over a two week period, the fastest drop in 17 years.

Many on Wall Street think that cheap money is the cure for our country's credit problems. However the tide is turning and cheap money is no longer the consensus solution. Many of the top economic thinkers and investors are starting to ask whether the "cheap money" era needs to come to an end. One prominent investor who is calling for an alternative approach is Bill Gross. He believes that it is time for a paradigm shift. He argues that U.S. and global demand has been driven for years by financially engineered lower interest rates and cheap credit. He believes our economy needs government help, and probably in the form of "a well constructed, more than temporary fiscal/monetary stimulus plan." I think Gross argues this point effectively, though I am always wary of government intervention: "because demand in the form of consumption has been artificially and fictitiously stimulated in recent years by financial engineering run amuck, there is a legitimate question as to whether its black hole imploding destructiveness can be totally countered with another dose of lower yields and deficit spending packages."

Mr. Gross' ultimate point:

My point is that Chairman Bernanke must recognize the reduced benefits and obvious dangers of a déjà vu trek to 1% short rates. Those yields produced 5% 30-year mortgage rates to the homeowner for a 2-3 month period in 2003 and they could do so again, but bubble creating, inflation inducing damage to the U.S. dollar would be the likely result now. Best to stop far short of 1% and at the same time encourage reforms in FHA government assisted programs that would permit subsidized mortgage rates with minimal down payments.

An artificially low, 1% short-term interest rate was an elixir during the days of a burgeoning shadow banking system. It cannot be the solution now.

Well it looks like Bernanke has failed to heed Gross' advice just yet and continues to use up a lot of his dry powder to prop up the weakening US economy. We'll have to wait and see how much lower he'll take rates before he realizes that another shot of liquidity won't help the economy much.

Note: In our quarterly newsletter sent out to clients I had predicted 3% short interest rates by the 4th quarter of 2008, but never thought we'd hit 3% in January!

Hat Tip: Bill Gross

Bill Gross Predicts a 3.5% Fed Funds Rate

Bill Gross' November market commentary is up on the PIMCO website. In it he pokes fun at Citigroup CEO Chuck Prince for his colorful commentary back in July regarding potential exposure to bad private equity-related debt: "As long as the music is playing you've got to get up and dance. We're still dancing." Turns out Prince probably should have stopped dancing, or at least kept his mouth shut. Investors probably won't look to kindly upon Prince dancing his way to a $6.5 billion writedown.

More important than Chuck Prince however is Gross' outlook on the US economy going forward and particularly his outlook on what Bernanke must do to bail us out:

So both old-fashioned banks and their derivative, conduit-fed shadow counterparts will be growing their balance sheets a lot more slowly in future months and quarters. That rather immediately translates into a slower economy and the need for government assistance in the form of lower interest rates or liquidity pushes like Treasury Secretary Paulson’s “Super SIV.” Whether Paulson’s “Committee to Save the World – Part II” will succeed like Bob Rubin’s original during the Long Term Capital crisis is debatable. The idea, first of all, is counterproductive because it continues to hide subprime asset prices in the “shadows.” Secondly, Rubin confronted no regulatory headwinds back in 1998, nor did he have to deal with today’s behemoth shadow banking system in the process of losing its brave face. Rubin in fact, along with his all-star committee featuring Alan Greenspan and Larry Summers, had a near hurricane force tailwind with 24 months more of dotcom IPOs yet to come. No wonder that Chairman Greenspan needed to cut short rates by only 75 basis points before stabilizing the economy nearly a decade ago.

Ben Bernanke has no such luxury. While he does have the backstop of a global economy powering on at a 4-5% annual clip, today’s U.S. IPOs were more a creation of leverage and the shadow banking system’s ability to create productivity gains through finance, as opposed to technological innovation. With banks and their shadows in retreat and modern day “world saving committees” relatively impotent, Bernanke must do some heavy lifting as opposed to the light housework required of Alan Greenspan in 1998. An increasingly recessionary looking U.S. economy will likely require 1% real short rates and 3½% Fed Funds in order to stabilize a potential growth contraction in lending not witnessed since the early 1970s or, to be honest, Roosevelt’s depressionary 1930s.

So here at the beginning of another Fed week we should look for another 50 basis point cut in the Fed Funds rate as Bernanke seeks to preempt further weakness. This would still leave another full percent for Bernanke to cut before approaching the 3.25% that Gross is predicting. While the smart money is on a 25 basis point cut, I'm going to break from the mold and predict a larger move. Look for this cut to further weaken the dollar and lead to another commodity rally. It is now within the realm of possibility that oil could reach $100 before a cyclical slowdown in the winter. While $100 a barrel oil seems amazing, this isn't the first time we have seen it before. Below is a graph courtesy of James Hamilton at Econbrowser:

Dollar price per barrel of West Texas Intermediate divided by ratio of CPI for the indicated month to the present value.

The other thing to look for is for a major announcement from a foreign central bank that they are officially removing their dollar peg. There is already a great degree of consensus among Gulf executives that removing the dollar peg would help their economies. Of the six major economies in the Gulf region, five -- Saudi Arabia, Oman, Qatar, Bahrain and UAE -- maintain a dollar peg. The sixth, Kuwait, removed their peg in May. All are dealing with serious inflation issues, and are unable to fight against the inflation because of the devaluing dollar.

The Age of Turbulence

Alan Greenspan's new book -- The Age of Turbulence -- comes out on September 17th. September 17th is significant for another reason however; it is the day before the next Federal Reserve meeting. This meeting might well be the most important of Chairman Ben Bernanke's tenure for a couple of reasons. First, this is the first time in over a year the consensus is that Chairman Bernanke will lower rates a quarter point to 5%. Second, this is the first Fed meeting after the credit crisis and represents the first major opportunity Bernanke has to distinguish his policies from those of Greenspan (namely on the Greenspan put issue).

The result of the meeting remains to be seen. But, one thing is for sure, with $100,000 speaking engagements, lucrative consulting arrangements (with the likes of German giants Deutsche Bank and Allianz's Pimco) and a healthy $8mm advance for his new book, Greenspan is finally cashing in on all those years he put in at the Fed. Surely Bernanke can expect similar treatment at the end of his term.

Bill Gross Says Enough is Enough

It seems everybody is talking about Bill Gross' investment outlook for August 2007 entitled 'Enough is Enough.' In it Gross opines on growing income inequality in America as well as excesses in the credit markets.

If you want to stay on top of what Gross is saying I encourage you to head over to the PIMCO site and subscribe to the updates via email. (I'm still waiting for them to add a feed to the page . . . . .)

I encourage you to read "Enough is Enough" in its entirety here.