Cutting rates on 'potential' economic slump? The horror!

Sarcasm is hard to avoid after reading a Bloomberg article titled "Bernanke Cuts on Slum 'Potential', Adopting Greenspan Approach"

After all, isn't avoiding 'slumps' the main job of central banks? Or do they have to wait until a full-blown recession to start cutting rates?

The problem, as always, is semantics. As George Orwell noted long ago, sloppy language leads to sloppy thinking. This is very much in evidence in this article, as in most financial journalism. Concretely, one has to determine what is understood by 'potential slump'

I'm pretty sure that the author meant was that Bernanke sought a rate cut to insulate the economy from the turbulence in financial markets, much as Alan Greenspan did by cutting rates after the Russian debt/LTCM debacle in 1998.

But that analogy is incorrect. In 1998, the U.S. economy was cruising along, growing at an annual rate well over 3% in the first half of that year. Thus, the rate cuts were purely preventive in the sense that market turmoil might have led to a downturn if no action had been taken.

The situation is very different this year. A sharp slowdown, though not a recession, in the economy was pretty evident well before turmoil hit the markets. In fact, while the credit crunch will certainly aggravate the recession in the housing sector, this downturn mostly reflects an imbalance in housing supply and demand that, while obviously related to financial factors, is not determined solely by them.

Thus, the rate cut is not 'preventive': the threat of a housing-led recession is very real and growing, with the current market turmoil clearly contributing to it.

With all due respect, the persons that question the rate reduction on moral hazard (bailout) grounds are nuts, as they're asking the Fed to not do its job. The other set of critics, who state that the Fed is underestimating the risk of inflation, are on firmer ground, but not much. After all, core PCE inflation is below 2%, within the Fed's informal range, and the economy is growing below potential.

Ben's Soothing Tonic

It seems Dr. Ben decided that the patient was best served by having the patient down his medicine in big gulps rather than sips.

With short-term Treasury rates near 4.2% at the end of last week, the markets were pricing a full percentage point cut in the Fed's reference rate over the next few months. So today's decision was merely a question of how quickly the Fed would deliver. Apparently, it is alarmed enough (not surprisingly given the run on Northern Rock in the U.K.) to prescribe a large, 50 basis point dose, even if that means losing some face.

The statement offered little insight. More surprising was the massive reaction in stock prices (the S&P 500 ended 2.9% higher). I think there are two possible explanations for this reaction:

1) Lowering the cost of credit will ease losses and restore liquidity to the markets. Everything will be sunny and it'll be like the two past months never happened.

2) The economy is in danger due to the woes in the housing sector. It's good that the Fed recognizes the magnitude of the threat and is beginning to act accordingly.

Obviously, numero 1 is mucho more likely than 2, as far as investor opinion is concerned. Needless to say, I'm in the #2 camp.

Actually, make that #3: the economy is in much worse shape than generally assumed and things will get a lot worse before Ben's Magic Tonic begins to take effect in a few months. Today's reaction in stock prices was not warranted.

Before calling me Dr. Tangible Gloom, chew on this: everyone has massively, consistently underestimated the problems in the real and financial sides of the housing market, as well as their impact, over the last couple of years. I don't see that changing, yet.

Judging the Fed

Naked Capitalism provides an excellent, in-depth summary of the debate on whether the Federal Reserve did the right thing by intervening in the markets (hat tip: Mark Thoma).

Today's word is BAILOUT

Yes, it's back with a vengeance. From every corner of the kingdom (see here and here), analysts are screaming "Bailout!" in response to the Fed's reduction in its discount rate and change in policy stance.

But is it? The premise of the criticism is that the Fed has rescued Wall Street and well-heeled investors in the recent past (the 1998 LCTM debacle, the tech bubble), thereby encouraging even more reckless behavior, such as that associated with the subprime mess.

Excuse me, but this doesn't make sense. LCTM did go bust, many persons lost fortunes speculating on Russian debt, and the Nasdaq is at half the level it reached in its 2000 peak. And cutting rates now won't do much to reduce the losses in bonds backed by junk mortgages. So it's not a question of rescuing investors, but of making sure that speculative excesses don't spill over to the economy. I don't blame the Fed for doing what it's doing (albeit in a rather clumsy way).

The hissy fit over alleged bailouts is unhelpful, as it distracts from asking the truly important questions:

1) Why have there been so many speculative excesses in such a short period of time?
2) Should central banks actively try to nip bubbles in the bud?
3) Do hedge funds and other highly-levered investment vehicles need to be regulated more strictly as potential sources of financial destabilization?

Have you seen anybody discussing these points lately? Neither have I.

Is the Fed bailing out Wall Street?

Now that everyone has had a couple of days to digest the Fed's actions, many have come to condemn them as the latest edition of the "Greenspan put", that is, bailing out Wall Street's scoundrel speculators. None other than the great James Surowiecki dixit.

Trends in credit spreads support this view. As James Hamilton points out, they've certainly risen, but only towards their long-term average (BAA-rated corporates are only slightly above 200 basis points above Treasuries).

While I do believe this view has a lot going for it, there are two big caveats.

First, we still don't know (and won't know for many months) where the weakest link is in the financial system and the disruption it may cause. The Fed obviously has a lot more inside info than any analyst and is in a better position to judge this. If it's worried by what it sees, a down payment on further easing makes sense.

Second, there's still the fundamental issue: house prices. While so far the adjustment is in line with the last big housing downturn in the early 1990's, leverage is much, much higher today, so things could get uglier. Certainly, the Fed foolishly downplayed the whole supbrime mess over the past few months, as many are pointing out. Nevertheless, some monetary easing might be justified to avoid a vicious circle from developing.

Talking about bailouts is not helpful. The losses for investors and homeowners are real, justified and won't disappear even if the Fed eases rates some more. The Fed's job is simply to make sure they are absorbed in an orderly fashion and we should judge it by this parameter.

It's official: panic in the markets

I somehow missed this earlier today. When central banks start injecting money into the system, you know it's getting really ugly, really fast.

Will this wall of money do any good? Well, sure, in the short run, although arguibly the signal it sends will work in the opposite direction.

What's really hurting the market is that nobody knows what those securities backed by subprime mortages are worth. If the meltdown continues, I wonder if the Fed will be willing to buy those bonds at a certain price.