The question for the Fed: Will further rate cuts help or hurt the credit crisis?

The Fed has been cutting to support the financial sector, and address risks (as they see them) of financial sector issues spilling over to the real sector.

How does the Fed see rate cuts helping the financial sector?

Lower payments for borrowers assist in servicing/refinancing outstanding debt and facilitate continued ‘borrowing to spend.’

However, in this cycle, it seems that rate cuts have been instrumental in the USD decline that correlates with rising gasoline/food/import prices.

‘Well anchored’ wages mean consumers are spending more on food/energy and have less for other goods and services.

And less for debt service, as evidenced by rising delinquencies and the (still mainly subprime, but starting to spread) deteriorating credit quality of consumer loan portfolios.

Yes, exports are increasing dramatically, supporting GDP, keeping the output gap reasonably low, but not increasing income for debt service where that is needed.

So the question for the Fed is, on balance, will further rate cuts help or hurt the credit crisis?

Will further cuts ‘ease financial conditions’ via interest rate channels?

Or will further cuts ‘tighten financial conditions’ via the current fx/inflation/debt service income channel?

And, even if those potential outcomes for the credit crisis are approximately equal, does the nod go to not cutting for reasons of residual inflation issues?

So far, not a single ‘real economy’ company has had problems beyond a slowdown in earnings and concern over future earnings. And slowdowns in sales have all been related to consumers being hurt by higher food and energy prices.

This implies the falling dollar/higher import prices is what has hurt the companies that have been subject to consumer weakness.

This implies Fed policy designed to protect the real economy from from potential spillover from the financial sector crisis has, as a side effect, done direct damage to the real economy.

And, of course, this is only relevant for the Fed if it comes up for discussion at the meeting on Tuesday.

Close friends tell me it probably won’t.

9 Responses

  1. Being the uneducated poor farmer that I am, isn’t it obvious to everyone that “pushing on a string” aint workin? How long will it take for a Volker type person to bring us a quick fix and jack interest rates? Could it be a “lost decade” long problem? Why didn’t Japan adopt the Volker type scenario instead of the one they did choose? How bad do you think it can get Warren, for how long? Nouriel Roubini makes me have nightmares and scares my children. Perhaps the fed can’t do anything, President Bush keeps saying over and over we have to break our dependence on foreign energy.

    Warren I have been told JPM owns 45% of the fed, and all this counter party stuff with bear sterns means they will make the little guy like me the sacrificial lamb to save their yachts.

    Then I watched CNBC the other day and Jimmy Rogers is telling Bortiromo that we must abolish the fed and Ben should resign. That markets then will be more self reliant and depend less on the government, ratings agencies, etc etc to do their “devil in the details” hard work and it will make the world a better, more robust place and make it harder for yacht owning wall street elite to sucker dumb poor farmers like me.

    He confuses me though. The Govenator Schwarzanegger is a tough guy, but they just laid off 10,000 california teachers. I would rather deficit spend and keep those folks employed than have thier “idle hands” raping my fields and pillaging my daughters as the Bible talks about. Governator is tough, but I doubt even he can beat off 10,000 hungry teachers!!

    My granpappy said a democratic president and high taxes and declining dollar (through inflation) was a cheap price to pay to keep otherwise roaming thugs from stealing the corn in his fields.

    His granpappy however though a good culling of human beings through war, famine, disease, etc etc also was a good thing. Thankfully it seems most people would prefer my granpappy’s memes to my great granpappy’s!

  2. Paul,

    I’ll let the word ‘bailout’ go for now, and begin by saying the liability side of banking is not the place for market discipline, and it’s also probably not the place for market discipline for the Fed’s appointed (annointed?) ‘primary dealers.’

    (I will also not here question the idea of having primary dealers in the first place, but don’t take that mean i approve of that setup, thanks!)

    So given the Fed wants primary dealers, it then follows there are specific securities they go along with this assigned role.

    Presumably those would include the likes of tsy secs, maybe agency paper, maybe AAA rated mtg backed securities, etc.

    Presumably also are functions the Fed wants its primary dealers to perform, like being market makers, providing some notion of liquidity, etc. etc.

    And, presumably, the Fed has some notion of public purpose behind this entire creation.

    So, given all that, to support this ‘institution of public purpose,’ it behooves the Fed to ensure the primary dealers themselves have the available lines of credit to perform this vital public function (almost hurts to write that…).

    The bank primary dealers do have ‘guaranteed liquidity’ and so are safely able to function as primary dealers, knowing they can always finance their inventory positions. This can be done via raising fed ensured bank deposits, and borrowing from the fed by using their inventory as collateral, etc.

    The non banks were at a disadvantage to the banks in that they relied on the banks to fund their inventories.

    Bear Stearns got shut down when the banks said ‘no’ for non credit related reasons. Bear had perfectly good collateral that they held as part of their primary dealer function (as defined by the govt regulations), and the banks said no, perhaps because they had their own internal issues.

    The same would happen to the banks, and the entire economy, if the Fed simply said no to the banking system and one morning and didn’t open the payments system.

    It’s just one of countless flaws in the institutional structure that doesn’t get noticed until it’s a problem, no matter how many times I’ve pointed it out to ‘authorities.’

    So to your question, while I do see a lot of other moral hazard issues, I don’t see this as one of them.

    The Fed simply told JPM to deal with Bear in the normal course of business and lend vs qualifying collateral as has always been the case, and as is the case when the Fed lends to JPM.

    Let me know if I’m missing something, thanks!


  3. Too many questions! I’ll select a few.

    How bad can it get.

    a. financial sector- churns and burns for several quarters, with some elements leaving it all behind and moving on, particularly the non bank dealers, insurance companies, regional lenders, etc.

    b. real sector- does well with export boom continuing due to the stampede out of $US financial assets by non residents and our own pension funds.

    c. US consumer continues to get squeezed by rising price and ‘well anchored’ wages. Employment holds up, especially as the fiscal adjustment kicks in and exports continue to accelerate, but real wages are held in check.

    The vestigial private ownership of the fed thing is not a factor. yes, a few shares are owned by old line banks, etc. but they get a fixed coupon (5%) and have no say in anything. All fed profits go back to the tsy.

    With a floating fx policy the govt has to set an interest rate as a point of logic, not ideology or philosophy. It’s like if you open a bus company in a city where there isn’t one you have to set the price of a ride. you might set it ‘wrong’ but you still have to set it. That’s the nature of ‘imperfect competition.’ I had dinner with Jimmy once years ago and he doesn’t get it at all when it comes to the exchange rate regime and fed operations. All he says is empty inapplicable rhetoric. He is, however, a good reader of markets and the market forces at work, and knows a bull market when he sees one, and also knows an inflation when he sees one, and has made some very good calls (ok, some not so good, but what do I know, I’m still short a few eurodollar futures and feeling very stupid)

    Yes, it’s a total waste to send needed teachers to the unemployment line. (If they are not needed and there is a place to employ them deemed better for public purpose that’s another story. see ‘soft currency economics.’)

    But the US States do have to maintain fiscal responsibility or they will go insolvent (unlike the fed govt.) so it’s not their fault. the fault is with the fed govt.

  4. warren wrote: “US consumer continues to get squeezed by rising price and ‘well anchored’ wages. ”

    It seems rising wages would allow for many of the current issues to be inflated away in a similar manner as in the 70’s. Could you speculate on realistic ways wages might become ‘unachored’ in the 00’s?

    Return of unions?

  5. Employers having to pay enough to allow people to drive to work and eat? If they don’t the employee quits and collects unemployment and other public assistance, or just doesn’t work if he doesn’t need the money, as it’s just not worth it?

    good point, though.

    and govt workers get automatic cpi increases each year, as do many others.

  6. Winslow how could unions possibly return when we live in a global world with capital spreading to almost 200 countries with all kinds of different corrupt politicians, laws, religions, economics, social structures, etc etc – I saw sally field in a movie about organizing a union, but that same person couldn’t go to Iraq, India, Gambia, etc etc and pull the same trick twice. Bhagwati is for globalization, but its like my old friend from croatia, he wanted the US borders wide open for him to become a citizen, but after he got in the door he wanted the border closed to all muslims and people from the goat herder side of Croatia 😉

    Warren always love your comments:

    [quote]Employers having to pay enough to allow people to drive to work and eat? If they don’t the employee quits and collects unemployment and other public assistance, or just doesn’t work if he doesn’t need the money, as it’s just not worth it? [/quote]

    My granpappy was spinning in the grave when his ghost heard eliot spitzer had to pay 5K per hour for a girlfriend (and still couldn’t get what he wanted!!!). I used to work for IBM before I went back to the farm Warren, and the cost to maintain a sexual relationship became far too expensive for me about a decade ago. I still had a lot of work to contribute to computer science, algorithm theory, black box trading, etc etc. Next to the spitzers of the world I couldn’t get what I wanted though, so this mule sat down and was no longer productive. Then all I did was read BBS posts 😉 Money is not going to fix the problem, I see the entire society needing a REBOOT and new values being taught to new citizens where crime, greed, corruption, drugs, etc etc have not become such large forces in so many people’s personal lives and society in general. I think american workers are overpaid and live too well next to much smarter, harder working folks in other places because we have the big guns and military and they do not.

    If Paulson was to call every “currency manipulator” tomorrow and reverse his allegations and encourage them to hoard US dollars and imports skyrocketed and exports plummeted and the rest of the world peg their currency at 8:1 to the Dollar, what are going to be the long term soci0-economic effects? All our people will become dumb non producing shopping machines and all the rest of the world will become hardworking smart skilled engineers no? Now you may have watched star trek as a kid, would you rather be in a nation surrounded by Spocks who are smart and productive or useless consumers who only know the latest fashions at abercrombie and fitch?

    Certainly a consuming nation of shopping machine princesses whose only skill is to pass on to their children also how to be princess shopping machines is not an ideal long term goal for the diversity of the skillset of a national citizenry eh?

    I walk in the mall in Miami and I see a human being who only knows how to shop for new louis vitton handbags and eat trendy salads with exotically flavored dressings. They do not know basic elementary level physics, economics, finance, take your pic of hard science. They don’t even have any really useful blue collar skills like cooking, cleaning, washing, etc etc. It was not passed down to them from their shopping machine parents.

    All they know how to do is shop, perhaps I don’t really understand you when you seem to be advocating policy that would seem to continue this culture of consumption when already our kids are getting so dumb all they want to do is walk into the schoolyard and kill all their mates because they are spoiled rotten.

    As to the primary dealer “system” It seems to me you cannot hold 7 billion humans to one set of law – the BORG was a nice idea in star trek, but that is fantasy. To even hold 300 million human beings to the same standards just in the USA seems silly to me as well. The banks in new york know new york, the banks in miami know miami, all my realtor friends in palm beach love it when a dumb sucker yankee comes down to “invest.” The skill sets and investment experience they have for a new york or london market may not apply to Miami. You lose flexibility when you start building the tower of babel really high, in network design a peer to peer internet is much more robust than a one server million client system, if the server goes boom, you are dead. Why does the same assets and collateral that are good in Danville, Ohio considered to also be good in Miami? You can’t paint the whole country with such a broad brush as that eh? I was in the title loan business for awhile, the laws in one state did not make sense in another state, the customer demographics were different. A loan that works for a young couple in bute, montana is not the same kind that works in Key West, Florida or Beihjing China. Local bankers get the experience of the local market and what is good and bad, you start going to a national or global command and control system and the rules are not able to adapt to what may be best and most efficient for the local market. I am still the john henry level of understanding all this though and have learned so much (and still learning) from you and winslow and all the other people who post here frequently. Thanks.

  7. go on the net and read the glyphs from the workers at the pryamids from 4,000 years ago. ‘my daughter is dating a carpenter (who doesn’t make much money) and i think she can do better.’

    reread ‘gulliver’s travels’- could have been written yesterday about today’s political goings ons. well worth a re read. you might even decide to live with the horses as he did.

    human values are hard wired in. won’t change without some serious genetic engineering, and then no telling what direction it may go.

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