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THE FED: WHAT SHOULD HAPPEN TOMORROW (6/25/08)

What really happened …

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

Recent information indicates that overall economic activity continues to expand, partly reflecting some firming in household spending.  However, labor markets have softened further and financial markets remain under considerable stress.  Tight credit conditions, the ongoing housing contraction, and the rise in energy prices are likely to weigh on economic growth over the next few quarters.

The Committee expects inflation to moderate later this year and next year.  However, in light of the continued increases in the prices of energy and some other commodities and the elevated state of some indicators of inflation expectations, uncertainty about the inflation outlook remains high.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time.  Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased.  The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

The Federal Reserve: where good intentions often yields bad policies …

The dot com fix …

A new paradigm ruled in our land. Companies that produced little or no profit or burned cash at an obscene rate were suddenly valued by investors at multiples that boggled the mind; simply because they had a story. A promise of producing radical change in the world and reaping untold gazillions in the process.  Millionaires were common place, multi-millions were created overnight and instant paper billionaires were not unknown. And it all came crashing down as the stock feeding frenzy turned into a downward spiral into a black hole of nothingness.

In order to fix our economy and assist in the recovery from the dot com bubble bursting, the Federal Reserve kept our Federal Funds rate artificially low, bottoming at one percent.

The global pool of money which previously seemed to be perfectly satisfied in investing in safe Treasuries was in the process of doubling due to a weak dollar and the expansion of exports. Money managers now looked around for something more than a one-percent yield and fixed their eyes on mortgages. Since investors did not want to deal with foreclosures and actual day-to-day mortgage operations, they turned to Wall Street to abstract the operations out of mortgage investing via derivatives backed by the mortgages themselves.

When everyone who wanted a mortgage already had one, Wall Street became frantic to keep the money flowing, so they kept relaxing mortgage standards until anyone that could sign their name could get one … even those who couldn’t afford to buy a car.

So now that the mortgage market imploded in on itself and the money managers continued looking for any safe yield greater than a treasury bond, they turned to investing in commodities.

Seeing that there was money to be made, Wall Street developed the ETF (Exchange Traded Funds) which would let the common man purchase commodities as easily as he could purchase stocks, not to hedge his actual crop prices or secure a stable price for the raw materials needed for his manufacturing plant  – but to play profitable games with paper.

So now we are, once again, in a growing bubble. We see a weak dollar and growing inflation about to wreak havoc on an already fragile US economy.

The dollar …

First they say that it is in the nation’s best interests to have a weak dollar to attract trade and help reduce the balance of payments issue. Then when goods and services are already selling at a thirty percent discount to the Euro and real estate prices are sinking lower each day, President Bush comes forward with the statement: “A strong dollar is in our nation’s interests. It is in the interests of the global economy.”

Inflation …

First they say that inflation appears to be under control and is moderating. Then when the cost of oil and commodities skyrocket as the global money pool seeks an above average return in commodities (remember Treasuries are being held at an artificially low rate and the mortgage game is producing negative yields), Fed Chairman Ben Bernanke says that “the danger of a ‘substantial downturn’ in the US economy has abated over the past month, but that inflation risks are increasing.”

So what’s really going on?

I have this nifty little spreadsheet program that calculates the imputed value of inflation over various time frames. Since I want to avoid being whipsawed back and forth trying to make short-term decisions on longer term events, I choose not to use the six-month, one year or three year outlooks. I look at the five year and ten year outlooks only.

As of  June 19th, my Fed Watcher program indicated that the FOMC would need to raise the Federal Funds Target Rate by  173 (1.73%) basis points just to return to a neutral inflationary stance in the 5-year outlook and 228 basis points (2.28%) to return to a neutral inflationary stance in the 10-year outlook.

The numbers for June 20th (made available on June 23rd) show that the Fed would have to raise the Federal Funds Target rate by 158-basis points (1.58%) to achieve a neutral inflationary stance with respect to the 5-year horizon and 217-basis points (2.17) with respect to the 10-year horizon.

Capture6-22-2008-2.45.27 AM

So what should the Federal Reserve do tomorrow?

If I were acting as one of the Governors of the Federal Reserve and sitting on the Federal Open Market Committee (FOMC), I would argue my case to Ben Bernanke and the others.

1.  The Federal Reserve has been faulted for always being behind the curve, acting only when things were dicey and the pressure was on. For issuing meeting announcements that were cryptic (a tip of the hat to Alan Greenspan who used lots of words to say nothing) to the point of encouraging rampant speculation as to the Fed’s next move.

2.  Wall Street has their own sharp operators and economists and it is common wisdom that the consensus opinion of what the Fed’s FOMC is likely to do is already priced into stocks, bonds and commodities. And that only bold action can move markets.

3.   I would recommend that the FOMC hike the Federal Funds target rate by 100-basis points (1%) and craft an announcement that essentially says:

(a)  the economy has slowed, but it isn’t totally stagnant – we are not in a recession – although some people feel like it is the end of the earth;

(b)  employment, a prime objective of the FOMC’s policymaking is disappointing, but not overwhelmingly bad;

(c)  the dollar is weak and it is now time to strengthen our national currency;

(d)   inflation has increased to the point of discomfort and we are going to aggressively going to attack it before it attacks us; and

(e)   I would add the customary weasel words: “we will monitor the situation closely and take the appropriate action.

What if they don’t take my advice?

My feelings won’t be hurt. Fed Watcher indicates a need for  raising the rates. The Fed’s use the very same numbers and techniques that I do. They know what is happening and the political ramifications of their actions. Whatever action they take, they can’t hide the results and Fed Watcher will continue to tell the truth.

However, an entry in the Wall Street Journal caught my attention.

"Then earlier this week, someone in the upper reaches of the Fed began leaking to the press in advance of next week's FOMC meeting that Mr. Bernanke saw no reason to raise interest rates this month, or indeed until the autumn. (Bernanke's Market Week; June 21, 2008; Page A8)"

As did this:

"For insights we turn to MKM Partners economist Mike Darda. Following is a synopsis of what was said during his interview on Fast Money:"

"I don’t think the Fed will raise rates next week, but they will probably harden the language they use when talking about inflation risk which got a bit more hawkish in the last meeting," says Darda. "Inflation expectations have been creeping higher and the Fed is trying to bat them down with talk and threats of action. Futures markets expect a 50 bps hike by November and a 75 bps hike by early next year. Personally, I think the Fed hikes this year, but probably not until the fall or winter."

Or this:

"This week traders have one thing and one thing only on their minds: the FOMC meeting, where the dollars fate will be determined. Analysts predict that Bernanke will leave rates unchanged, but the general feeling is the statement after the decision will be hawkish due to both high inflation and comments from US officials that the dollar should be strong. However, all that is easier said than done! The question is, will Bernanke "walk the walk" after all the hawkish comments heard in the last few speeches? If the statement fails to hint at any rate hikes for the coming months, the dollar will be sold off all across the board; as the market doesnt like it to be proved wrong! It will be very interesting to see the EUR/USD reaction afterwards and the outcome will either "make or break" the greenback." (Will This Weeks FED Rate Decision Give Dollar The Long Awaited Rally? -- (Lena Manousarides)

Hopefully, they are collectively smarter than I am and have better access to information regarding the market.

If they cut the rates once again, they will be severely criticized.

If they choose to do nothing and attempt threatening language, they will be criticized. Seriously, the expectations of most pundits is that the Fed will do nothing with the Federal Funds target rate and publish a statement that stresses inflation over the slowing economy (and possible recession). 

If they raise the rates 25- to 50-basis points, I believe that Wall Street will be relieved and the market may rise slightly.

If they raise the rates 100-basis points, I believe we will see a greater change in the market. I think that commodities will decline slightly ... and that the pundits will still criticize the Fed.

One should always remember, when the Federal makes a mistake, it will be a big one that hurts many people. It will hardly go unnoticed.  And the Fed Watcher doesn't lie!

-- steve


“Nullius in verba.”-- take nobody's word for it!

“Beware of false knowledge; it is more dangerous than ignorance.”-- George Bernard Shaw

“Progressive, liberal, Socialist, Marxist, Democratic Socialist -- they are all COMMUNISTS.”

“The key to fighting the craziness of the progressives is to hold them responsible for their actions, not their intentions.” – OCS

"The object in life is not to be on the side of the majority, but to escape finding oneself in the ranks of the insane." -- Marcus Aurelius

“A people that elect corrupt politicians, imposters, thieves, and traitors are not victims... but accomplices” -- George Orwell


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