The "Bailout and Justify" Fed

I can't think of a Halloween in recent memory that fell on a day with such a heavy dose of economic news. Not only are we getting some of the standard fare -- ADP private payrolls, construction expenditures, the employment cost index etc. -- we are also getting some real substance with the FOMC meeting and the third quarter advance GDP figures. The end result, if this year carries on as it has thus far will probably be bad economic news followed by a great rally. Allow me to explain.


As you can see above, the market has priced in a 25 bip rate cut heading into FOMC day. I personally think the Fed could, and may try to "justify" another 50 bip cut. How would they do that? Well for starters they could point out that market conditions haven't stabilized enough to cushion the blow from an accelerating housing market decline. After all that resilient American consumer is only as resilient as the credit officer who signs off on his/her HELOC's and credit card applications.

The Fed's second "justification" option is to just point at the graph above and use dramatic works like "crisis" and "carnage" to describe the credit spreads. Surely there is something in that chart to scare the weak-hearted and spin a 50 bip cut!

The reason I emphasize the Fed's need for justification is to point out how closely Bernanke's Fed seems to be following Greenspan's basic policy, as summed up in the following Greenspan quote from September of 2004 (and pulled from Jeremy Grantham's most recent newsletter): "For the Fed to interfere in security speculation is neither desirable nor feasible," but "if a sudden correction in asset prices did occur the Fed's first responsibility is to protect . . . to provide ample liquidity until the crisis is past." In plain English, Greenspan's stance is that you can't stop speculation, but you must bail out the speculators before they hurt everybody else. The real key of course is to bail out the speculators, but justify your bailout to market participants in such a way that they don't increase their inflation expectations. While this "bailout and justify" policy seems to be the preferred option for Greenspan and Bernanke, it does have a fatal flaw; it is quite simply not the type of policy that will force market participants to accurately price risk and thus prevent future speculation (moral hazard).

Now I want to make it clear that I don't think these moral hazard problems are necessarily Greenspan or Bernanke's fault. I think that the Fed Chairman's incentives, at least during this little slice of history, are just not in line with staying hawkish on inflation during market corrections. Indulge me on this for a moment. Back in early September Martin Feldstein suggested at the Fed's Jackson Hole Symposium that a 100-bip cut in the Fed Funds rate could be rationally justified. When reading the quote below from Feldstein's speech try to imagine yourself as the Fed Chairman listening to this speech and slowly letting your scholarly inclination to "stay hawkish on inflation and tough on speculators" slowly drift away and start thinking more about how posterity will view you if you precipitated a painful recession:

The Fed could adopt the risk-based "decision theory" approach in responding to the current economic environment. If the triple threat from the housing sector materializes with full force, the economy could suffer a very serious downturn. A sharp reduction in the interest rate – in addition to a vigorous lender of last resort policy – would attenuate that very bad outcome.

But what if the outcome in the absence of a substantial rate cut would be more benign and yet the Fed nevertheless cuts the federal funds rate? The result would be a stronger economy with higher inflation than the Fed desires, an unwelcome outcome but the lesser of two evils. If that happens, the Fed would have to engineer a longer period of slower growth to bring the inflation rate back to its desired level. How well it would succeed in doing this will depend on its ability to persuade the market that a risk-based approach in the current context is not an abrogation of its fundamental pursuit of price stability.

Wait a minute, hold the presses, since when did "Decision Theory" replace the Taylor Rule as the key factor in the Fed's decision making? While I don't think Marty was trying to illustrate the amazing power incentives have in encouraging moral hazard in Central Banking, he did a fairly good job of it. The acute pain of a recession is a far bigger and more salient pock mark on the track record of a central banker than that of a "longer period of slower growth." Just think, if you were Bernanke looking at the current state of the economy, and I was God and I offered you stability today followed by a "longer period of slower growth" or a 50% chance of a sharp recession that would likely be blamed on you, which option would you take? That's what I thought.

Following this line of thinking to its natural conclusion, it would also behoove an incentive-led central banker to underestimate the true inflation rate in the economy in order to provide more flexibility to cut rates in times of distress. And now we are at the truly scary part of all of this discussion. More and more scholars are starting to question whether the Fed's preferred inflation measures are truly capturing all the inflation out there in the economy. Jeremy Grantham -- a man who seems perenially worries about the market -- has not once been concerned about inflation for the past 20 years, that is until now:

For the first time in 20 years I am slightly worried about inflation. . . By the way, like many others I have an increasing distrust in the official inflation numbers.
For example, we have rising commodity prices and a very large deficit combined with a very weak currency, yet we have a decreasing inflation rate and one that is lower than that of many European countries with strong currencies. Very odd indeed.

Makes you wonder what exactly goes into the inflation calculation doesn't it? I'll tell you what. With what little I know about incentives it just seems to me that the Fed is more likely to cut big now and seek to justify than it is to rediscover its distate of inflation. I just hope all of you who have made it this far in this post have moved out of the dollar into commodities and emerging market stocks.

Sidenote: Just the other day Jim Rogers was quoted as saying: "It's the official policy of the central bank and the U.S. to debase the currency." While I think he was being a bit dramatic, I think he may have a very good point. China dropped its 'official' dollar peg 26 months ago and has allowed its currency to appreciate just 10% over that stretch. Now China is facing a serious problem: they are raising rates to fight rising inflation (6.2% in September, October numbers due in 2 weeks) and they are watching as the US lower rates (today) to fend off a recession. If the US is at 4.5% and China sees rates rise closer to 3.5 or 4% it won't be long before China's Central bank will actually be losing money if it continues to sterilize capital inflows. With the Fed in "decision theory" mode I might just follow Jim Rogers advice and start moving all of my assets into Renminbi . . .

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 Fall of the Dollar (and Rise of the Amero?)

Harvard professor Larry Summers frames the issue of the weak US dollar simply enough:

The falling dollar generates anxiety almost everywhere. Americans and those dependent on American growth worry about the proverbial “hard landing” as inflation and interest rates rise with a weakening dollar, causing asset prices and output to fall. Europeans and others with currencies that float freely against the dollar worry that their currencies will bear a disproportionate share of the dollar’s decline and appreciate too far, leading to competitiveness problems. The falling dollar risks rising inflation, asset bubbles and the loss of macroeconomic control in countries that have tied their currencies to the dollar’s sagging mast.

The dollar’s decline may provoke anxiety but it should not be a surprise to anyone who has followed the global economy in recent years. History suggests that periods when a country’s economy turns down, short-term interest rates are declining and financial strains are increasing are likely to be periods when a nation’s currency depreciates. Moreover the US current account has for years now been financing consumption rather than investment, with the financing coming increasingly from debt rather than equity and shorter rather than longer-term debt.

He then points out some inadequacies in the current manner of exchange rate management (or lack thereof):

There is nothing very new about a decline in currency of a country running a large current account deficit and whose economy is softening. But in important respects the situation of the dollar is almost without precedent.

The vast majority of the US current account deficit is now being funded by central banks accumulating reserves as they seek to avoid appreciation of their home currencies. While the US dollar is usually viewed as a floating rate currency, substantial and critical parts of the world economy operate with currencies pegged to dollar parities or at least managed with them in mind.

Finally he advocates for change:

This suggests the need for rethinking traditional approaches to dollar policy at a time when the global economy is more vulnerable than it has been since 1998.

The Clinton administration approach of asserting the desirability of a strong dollar based on strong fundamentals while allowing its value to be set on foreign exchange markets was highly successful in its time and has largely been followed by the Bush Treasury. But it is insufficient in the current world, where the dollar’s trade-weighted exchange rate is to an important extent managed abroad. Some means of engagement must be found with those who have yolked their currencies and so their financial policies to that of the US.

The US has responded in an ad hoc way by carrying on a “strategic dialogue” with China – by far the largest economy with an exchange rate linked to the dollar – backed by congressional threats to address exchange rate issues using the tools of trade policy and references to communiqués from the Group of Seven leading industrial nations. In reality the dialogue is anything but strategic. Like so much of American international policy in recent years, it seems to confuse the firm statement of legitimate desire with the serious conduct of diplomacy.

I think a new currency strategy is a must, but I am definitely concerned about what the "next administration" might come up with. If you hear me advocating for the status quo it is likely from a position of concern about the new policy rather than an expression of satisfaction with the existing policy. (Out of left field: Does Larry remind anyone else of Nouriel Roubini in saying the global economy is the most vulnerable since 1998?)

US policymakers aren't the only ones concerned about the weak dollar being financed by China. I read that OPEC is likely to review pricing oil using a basket of currencies rather than just using the dollar. I also wouldn't be surprised to hear about Middle Eastern countries dropping their dollar pegs. Our firm is actually going through a similar evaluation of our firm's currency overlay policy to determine if we should hedge our currency exposure to a basket currencies rather than arbitrarily using the US dollar as our home currency.

In all of this I think that one fact is abundantly clear; any policy change is better than a move towards the North American Union (NAU) and the Amero. The NAU is a President Bush supported idea to combine Canada, Mexico and the US into a Union to rival the rise of the European Union. The Amero would be the combined currency of the three countries. When I first heard it I thought it was definitely just a crackpot conspiracy theory, but then I saw this clip from Lou Dobbs (not that Lou Dobbs is the official arbiter of what is conspiracy and what is mainstream):



I think this interviewer was completely blindsided by the Amero discussion:


Here is a picture of the Amero. Looks harmless enough, eh? (I'm just getting used to being a part of Canada)
Hat Tip: Brad Setser

Images for the week

Maybe I'm just lazy and didn't want to write full posts, but this past week I've come across quite a few great self-explanatory images. I've included a few below:







Hat Tips: Barry Ritholtz, Greg Mankiw, Calculated Risk, Bespoke, WSJ

Fire Time Lapse Video

Microsoft Buys $240 Million Stake in Facebook

It was a two horse race between Google and Microsoft to determine who would buy a stake in Facebook and get the rights to broker Facebook's international ads. Today Microsoft won that race, purchasing a 1.6% stake in Facebook for $240 million. This is another move in Microsoft's strategy of regaining relevancy in the online advertising world after getting blindsided by Google in recent years. While this deal pales in comparison to the company's $6 billion purchase of aQuantive/Avenue A Razorfish it does signal that Microsoft is still willing to spend some of its $21 billion dollars of cash on key internet advertising assets.

This deal is also interesting because it gives us a real value for Facebook: $15 billion. Mark Zuckerberg probably has a big smile on his face right about now as he thinks back to the $1 billion offer he received from Yahoo about a year ago. Many thought Mark should have taken that offer, but obviously he's going to get the last laugh on this one. At $15 billion Facebook is bigger than the market capitalizations of Bear Stearns, H.J. Heinz and Baidu.com and is about the same size as Sempra Energy, Ameriprise Financial and Xerox.

To put all of this in perspective Sempra Energy has about $11.6 billion of revenue and roughly $1.1 billion of net income compared to Facebook's $150 million of revenue and $30 million of net income. Okay, okay I know comparing a technology company with a gas utilities company is comparing apples and oranges, but you must admit it is a sobering perspective. Before this deal I find it hard to imagine that Facebook had much more than $20-30 million of cash and Sempra has about $1.3 billion, but I digress . . .

The 100x multiple on trailing earnings may seem a little rich, but Facebook is also making huge gains on MySpace its chief competitor in the social networking space. It is also experiencing dramatic revenue growth, particularly from Canada and Asia. Even from a quick glance at Alexa the ground Facebook has made up is stunning. You may have to click the graph to really see it, but you can see how Facebook's daily reach as measured by Alexa has risen dramatically over the past year, gaining on Myspace all the while:
During September Facebook attracted 30.6 million US visitors to Myspace's 68.4 million. So although it is growing faster it still has some ground to make up. But, Facebook's control over the US market is not what excites investors. He's a blurb from a Wall Street Journal article that describes it well:

Facebook, a service that lets people set up their personal Web pages, is seen as the next big venue for placing online display ads. The company has nearly 50 million users, many of them the young audience that advertisers covet. In addition to selling ads on its own, the company over the past year has started placing ads through a deal it signed last year with Microsoft, under which Microsoft brokers banner ads on Facebook's U.S. site until 2011.

The deal signed today is an expansion of that agreement and focuses on international versions of the Facebook service, which Facebook is now starting to open. A deal with Microsoft would allow Facebook to shift some of the burden of selling international display ads to its larger partner. Microsoft in recent years has built up a large online advertising sales force and has invested in technologies to broker advertising over the Web.

By the end of this year, Asia will account for 35% of the world's social networking users, with 28% of users in Europe, the Middle East and Africa, 25% in North America, and 12% in the Caribbean and Latin America, according to research firm Datamonitor Plc.

It is that strong international growth, particularly in Asia that has investors giddy. I think if we have learned one thing at this point it is to not underestimate Mark Zuckerberg or Facebook. I think it is not beyond the realm of possibility to expect a Facebook IPO sometime in 2009.

Foreclosure Wave is Not Over Yet

I think this IMF chart is self explanatory:

Hat Tip: Calculated Risk

San Diego Fires

San Diego is experiencing some horrible fires today. In fact you can actually see the huge smoke plumes from satellite images (right). Hundreds of homes have burned already in a firestorm that has reminded many of the devastating Cedar fire in San Diego 3 years ago. The difference this time is that there are actually between 6 and 8 fires across the county and the high winds and Santa Ana conditions that provoked these fires are due to stick around for a few more days. The bottom line is that there are simply not enough firefighters to fight these fires. The vast majority of the firefighters are spending their time helping the 250,000 evacuees flee their homes.

Please keep San Diego in your prayers over the next few days.