The Float

Parsing the Fed

Here's the WSJ's comparative assessment of yesterday's Fed statement...

And here's a collection of economists' reactions assembled by the WSJ's Real Time Economics.

Thursday Miscellany

125 basis points later...

• ...and still expectations of additional rate cuts.
• Yves Smith passes along a Ricardo Hausmann piece from the FT. One highlight: "Main Street consumers have overspent and over-borrowed and are unable to meet their obligations. The fact that households may have so behaved because they were enticed by "teaser loans" does not change the facts; it only assigns blame. Consumption has been above sustainable levels and needs to adjust down, whatever view one has about the responsibility of adults over their financial decisions."
• Two good posts on mortgage equity withdrawal (noted Tuesday in this space) from Calculated Risk: "Advance Q4 MEW Estimate" and "Lenders Suspending HELOCs." The upshot: Equity withdrawal continues, in spite of falling home prices, as "homeowners" draw down their remaining equity to support their consumption. What's the problem with that? Go read that Ricardo Hausmann piece again.
• See Barry Ritholtz on the SEC staff's weakness on balance sheet rules for the financials.
• Bloomberg's John Berry: Notwithstanding the current rate-cutting fervor, the rate cycle could turn sooner rather than later.

Chart of the Day

Today's wild ride in the equity markets (see chart below) was a near-perfect encapsulation of the last several months. We had it all on display: Weak economic data to start the morning, caution and uncertainty before the Fed announcement, euphoric buying on a 50 basis-point move that had been "priced in" by investors, then, suddenly, the ugly reality of still-unwinding credit markets sending the broad market sharply lower (~30 points!) in the last 50 minutes of trading.

Interesting times, no?

Sources

Shobhana Chandra, "U.S. Economy: Growth Slows as Housing, Spending Cool," Bloomberg, January 30, 2008

Michael Patterson, "U.S. Stocks Decline as Bond-Insurer Concern Outweighs Rate Cut," Bloomberg, January 30, 2008

Wednesday Reading

All Fed, all the time...

• From Bloomberg's Craig Torres and Simon Kennedy: "Fed May Cut Rate Below Inflation, Risking Bubbles."
• What will the Fed do this afternoon? MarketBeat's David Gaffen collects several entries in the obligatory guessing game.
• Also from the WSJ: Real Time Economics weighs in on this morning's GDP report.
• Barry Ritholtz has more on those GDP numbers.
• Great stuff from Calculated Risk: Residential investment in historical context.

Interest Rates and Consumer Spending

With another reduction in the fed funds rate coming tomorrow afternoon, we have another chance to review the effects of the Fed's now-aggressive rate-cutting campaign.

We can say with confidence that lower fed funds means better net interest margins for banks. Thus the recent rally in the beaten-down XLF (see the one-year chart below, with a 20-day EMA in blue). But keep in mind that the financials have rallied a couple times before resuming the deterioration that began in June.

We can also say that a fed funds cut will produce a lower prime rate, as borrowers' equity lines of credit (HELOCs) reset at lower levels in relatively short order. In this sense, a lower fed funds rate will help borrowers service certain parts of their existing debt loads. That's no trivial thing. But the debt service--and credit contraction--story doesn't end there.

Here's a key passage from a recent BusinessWeek story on consumer spending (emphasis added in bold):

Fearful bankers are making matters worse by tightening their lending standards, which makes all sorts of consumer loans more expensive and scarce. The banks' caution comes out of sheer necessity. Their balance sheets are devastated after the huge mortgage write-downs of the last two quarters. And the industry's new conservative lending posture will make it difficult to resuscitate consumer spending with another jolt of interest-rate cuts. Banks are likely to keep raising rates on credit cards and other consumer loans no matter what Federal Reserve Chairman Ben Bernanke does.

Once again, it's lending standards that matter most. Next in the hierarchy: Borrowers' eagerness (and willingness) to incur still more debt. Take mortgage equity withdrawal. With residential real estate prices falling, all but the most desperate (or irrational!) homeowners will be very reluctant to leverage themselves further to their depreciating assets.

For years--years when real wages remained relatively flat--mortgage equity withdrawal (MEW) was a driving force behind the unstoppable American consumer. Now, with MEW substantially diminished, and not likely to rebound in a meaningful way any time soon, consumers are more strapped than ever. On the margin, consumers have entered a period of balance-sheet-restoration.

Given this country's unholy levels of private debt (to say nothing of our public debt), the rebuilding of household balance sheets is great, great news. But it will cause short- or medium-term challenges. Welcome to the business cycle.

Source

Matthew Goldstein and David Henry, "Tapped-Out Consumers," BusinessWeek, January 28, 2008

Courtney Schlisserman, "Case-Shiller Home Prices in U.S. Fall for 11th Month," Bloomberg, January 29, 2008

Understanding the "Stimulus"

We aren't members of the "let them eat cake" school of macroeconomics. But we do have our doubts about the effectiveness of the federal government's proposed stimulus package (see this, this, and this).

Here's an extended excerpt from John Hussman's latest weekly market comment (emphasis added in bold):

One of the ways that analysts talk about the just-enacted "fiscal stimulus" is by asking the question "How much of the stimulus will be saved?" To some extent, this is the wrong question, because if you think about it from the standpoint of equilibrium, the answer is obvious: exactly all of it.

The reason is simple. In equilibrium, every security issued must be held. If the government issues $150 billion of new debt to finance its outlays, then by pure accounting identity, exactly $150 billion of savings must be absorbed from someone to purchase that debt.

The trivial way for saving to absorb the stimulus would be for the Treasury to offer $150 billion in bonds, and also issue people $150 billion specifically for the purpose of buying those bonds. That's an instant wash. But even if the dynamics are different, the end result must be the same--someone must end up holding the new debt.

One might counter that the Treasury could sell $150 billion in bonds and the Federal Reserve could purchase them, creating $150 billion in new base money. Unfortunately, the entire U.S. monetary base is only $847.6 billion, up from $837.7 billion a year ago. Far from the notion that the Fed has created oceans of liquidity in the past year, the fact is that the U.S. monetary base (which is the only monetary aggregate the Fed controls with its open market operations) has increased by less than $10 billion. There's no shortage of previous weekly comments on this website that explain the distinction between repo rollovers and true increases in Fed "liquidity." The simple fact is that $150 billion is far beyond the capacity of the Fed to monetize without provoking a currency crisis.

Government itself is a zero sum game. The proposed "fiscal stimulus" amounts to the government issuing additional debt to some individuals in the economy, and allocating the proceeds to others. The only relevant issue is whether adding to the Federal debt in order to redistribute purchasing power will bring resources into use that otherwise would lay idle; whether the redistribution of purchasing power will relieve some constraint that would be binding in the absence of the program, in a way that ultimately increases economic activity.

...

If the government issues Treasury bonds and uses the proceeds to make tax rebates, it simply effects a transfer of savings from one party in the economy to another. A "fiscal stimulus" is not new money, but a redistribution of resources that relies on the hope that the new recipients will direct the money more productively than those who did the saving. Remember, people don't save by stuffing their money under a mattress. Rather, they typically invest it, so the savings are ultimately intermediated to a spender--even if that spender is the Federal government. The real question is not how much of the "stimulus" will be saved, but the extent to which the redirected resources of the economy will be used more productively than they would have otherwise.

Before enacting a "stimulus package," it would be helpful for Washington to recognize that a policy that loosens a particular constraint is only effective if that constraint was previously binding on the behavior of individuals or companies. If the Keynesian problem is that people want to save but investment is stuck, then R&D subsidies with a tight sunset timeline would be a good way to directly promote productive investment and channel savings into economic activity. That said, I don't think the problem with the economy is a sudden desire to save. It's a shift in the composition of demand away from the mix of goods and services (particularly housing and debt origination) that was previously desired. There's not a whole lot fiscal policy can or should do to bring back the "good old days" of irresponsible lending and housing bubbles. Once a market becomes overvalued--in stocks, bonds, or housing--either falling prices or poor long-term returns become inevitable.

For most families, the most binding constraint right now is not the ability to spend out of current income, but the ability to service debt. A temporary boost to current income is likely to be spread out in a way that best allows that family to operate under its constraints, which means that the predominant use of this "stimulus" will be for debt service. This may very well provide the economy with a modest reduction in credit strains, but it certainly won't avoid delinquencies and foreclosures. Most mortgage obligations will swallow down the entire rebate in a single month. Outside of bailing out credit institutions and creating a huge moral hazard problem down the road, there's not a whole lot that will solve the problems except time and writeoffs.

If you made it all the way through that, we suggest you read it again. It's that important.

And while we're on the topic of elected officials' imperfect understanding of economics, we recommend Chris Caldwell's recent New York Times piece on the changed composition of the American economy.

Sources

John Hussman, "Broadening Instability," Hussman Funds Weekly Market Comment, January 28, 2008

Christopher Caldwell, "Old-School Economics," New York Times, January 27, 2008

More Tom Toles

Our man Toles is all over the world of finance these days...

Not Remotely Scientific...But Vaguely Suggestive

This is a vanishingly small sample--so small it doesn't deserve to be called a sample--but all five of the households we canvassed over the weekend told us they'd use the "stimulus" checks they expect to receive from the IRS to pay down existing debt (and, in one case, to help pay a property tax bill).

Not, in other words, to run out and buy something they wouldn't otherwise have bought.

We'll be watching for real data on this question. Until then, see Caroline Baum's Friday column for more.

Monday Reading

Is it just us, or does every week seem like Fed Week around here...

• From the AP's Jeannine Aversa: Risks in Fed's Deeper Interest Rate Cuts.
• Bloomberg's Bob Ivry notes that the Fed funds rate is one thing, but market interest rates are, at times, very different critters.
• Pretty pictures from Calculated Risk on the not-so-pretty-picture that is December new home sales.
• Yves Smith points to spreading suspicion that global financial markets have reached a "Wile E. Coyote" moment.
• Just another winning headline for Blackstone.
• Good stuff from BusinessWeek's Michael Mandel on the effects of (very) free-flowing credit over the last several years.

Pedantic Language Post #2

A moment ago, we were subjected to an all-too-familiar error in usage, courtesy of CNBC's perfectly pleasant Sue Herrera (emphasis added in bold):

You know if you've been in gold lately, you know that that metal has literally been on fire.

We assume the problem with that formulation is self-evident. But just for kicks: Unless Herrera and her trader friends have roasted their gold something fierce, the yellow metal has decidedly not "literally been on fire."

Figuratively? Yes. Metaphorically? We'll give her that too. But literally? No.