Wednesday, June 4, 2008

Talking Tough

So, Big Ben finally decided to defend himself. The speech he delivered today arguably provided the world with the first candid discussion by the Fed Chairmen on the global credit crunch. He lays things out pretty clearly by breaking the speech down into three parts 1)what’s happened 2)outlook 3)how we’ve acted and why. In my opinion, the outlook and policy response sections reveal a lot about the challenges facing policy makers today.

Some interesting quotes from the chairman;

“However, until the housing market, and particularly house prices, shows clearer signs of stabilization, growth risks will remain to the downside. Recent increases in oil prices pose additional downside risks to growth.”

Loose translation- We are still very concerned about consumption and output risks in general. Monetary Policy should remain accommodative.

“Unfortunately, the prices of a number of commodities, most notably oil, have continued upward recently, even as expectations of future policy rates and the foreign exchange value of the dollar have remained generally stable in the past few months. The possibility that commodity prices will continue to rise is an important risk to the inflation forecast. Another significant upside risk to inflation is that high headline inflation, if sustained, might lead the public to expect higher long-term inflation rates, an expectation that could ultimately become self-confirming.”

Loose translation- We are concerned about inflation, and the risk that we may have permanently let the inflation monster out of the bag. Monetary policy may need to shift in a more restrictive direction

The market’s interpretation of this mixed message: Fed is done cutting. Dollar rallies, commodities fall, and equities catch a slight bounce because of the dollar. The problem with this interpretation is that nothing has really changed, and if the fed has really shifted into neutral; equity markets will run into some very strong headwinds in the future now that the prospects for further easings have diminished. There really is nothing for the fed to do but to keep talking tough while simultaneously being as accommodative as they can be without absolutely killing the dollar. In this situation, the dual mandate cannot be fulfilled. The fed made a decision a few months ago to save financial markets and asset prices from a sharp and painful correction. To accomplish this they sacrificed price stability. It’s really pretty simple. See, a decade of imported deflation from Asia and increased productivity provided them with some breathing room to bail out the markets. But markets are ruthless, and as a result the breathing room is now gone. Big Ben can keep talking, but he’s already showed his hand. The whole world knows he suffers from deflation phobia, and thus will do whatever it takes to prop up asset prices.

In my opinion, this fed can’t fight inflation without administering a lethal injection to asset prices. So, how will this all play out? Well, I think heightened inflation expectations are here to stay. Eventually higher prices will eat into corporate profitability and force equity multiples down. During this adjustment period economic growth will remain well below trend, and this will eventually lead to stability in commodity prices as demand will come under pressure. This economic scenario will play out over a few years and not at the hyper speed that wall street operates at. The fed has succeeded to the extent that the economy slows as gradually as current reported data indicates. But make no mistake…if we get some nasty employment number or gdp data….everyone will be calling for more rate cuts…and the fed will give them what they want.

As for the moral hazard debate, here is what Big Ben had to say

“The Federal Reserve's mandate is to foster maximum sustainable employment and price stability. To achieve these goals, we must also support the return of financial markets to more normal functioning.”

I have but one question for Big Ben- What is normal functioning in financial markets?

Rampant credit creation, irresponsible lending, inadequate risk controls, insane compensation, and activity that borders on the criminal. These things happen because financial markets can count on your support.

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