We are evenly split on whether the Fed will cut 50 or 75 basis points this afternoon. 100 or more basis points would reflate equity markets but put the dollar in freefall unless the Fed also wraps restrictive language around it signalling a firm pause.
We return to our analogy of Scylla and Charybdis. The Fed's task is to navigate between a falling dollar and broken bond on one hand, and the real economy and the equity markets on the other. Its a difficult task, made even more difficult as we approach what the Fed likes to call 'the zero bound.' We call to mind Chairman Bernanke's game plan as discussed in his academic writings:
"Bernanke and Reinhart (2004) discuss three alternative, though potentially complementary, strategies when monetary policymakers are confronted with a short-term nominal interest rate that is close to zero. As discussed in the introduction, these alternatives involve:
(1) shaping the expectations of the public about future settings of the policy rate,
(2) increasing the size of the central bank’s balance sheet beyond the level needed to set the short-term policy rate at zero (“quantitative easing”); and
(3) shifting the composition of the central bank’s balance sheet in order to affect the relative supplies of securities held by the public."
It is deceptive to think that the Fed will wait until US short term rates are at zero to implement these strategic options. Indeed, they have been trying to shape expectations for some time through both talk and selective price manipulation of certain financial assets, as Mr. Bernanke discloses in his paper using supply and demand dynamics of select financial instruments. Shifting the composition of the Fed's balance sheet is well underway with the non-recourse additions of junk mortgage debt to the Fed assets once pristine with Treasuries and the better agencies.
The next shoe to drop will be the methods by which the Fed "increases the size of their balance sheet" quickly enough to achieve a quantitative easing. Several commentators are calculating the Fed held assets as they approach zero as the Fed extends its assets to the banks and exchanges them in a variety of swaps.
We suggest it is probably incorrect to assume that when the Fed expend the remaining three or four hundred billions of existing Treasury holdings that they will say 'game over' and call it a day. That when we leave the trodden path of monetary history and the US attempts to break the final bonds of a purely fiat currency.
IMF External Relations Department
Morning Press
Tuesday, March 18, 2008
Pressure on Fed to slash interest rates
The Federal Reserve faces pressure to cut interest rates by as much as a full percentage point or more at its scheduled policy meeting today, the FT reports. In early trading yesterday, options prices indicated roughly even odds of a 75basis-point cut or a 100-basis-point cut - with some traders betting on an even bigger 125-basis-point reduction from the current rate of 3%. This puts the U.S. central bank in a difficult position. Before the latest deterioration in financial markets and the crisis at Bear Stearns, policymakers were signaling their reluctance to cut rates by more than 50 basis points at this meeting.
They wanted to indicate that they were still committed to managing inflation at a time when the dollar has been plummeting, commodity prices soaring and market expectations of inflation and inflation risk mounting. Fed policymakers are increasingly doubtful that the risks facing the financial system and the economy can be dealt with through orthodox monetary policy alone. So far interest rate cuts have been largely offset by the expansion in credit spreads. While some on the committee believe this calls for still more aggressive rate reductions, others are concerned that if the central bank cuts rates too aggressively in the face of inflation risk, the bond market could rebel, pushing long-term interest rates up.
But developments in the economy and above all the financial markets in recent days are likely to push policymakers to consider more than a 50-basis-point cut. Above all, financial markets are in a state of extreme dysfunction, which extends to the core of the housing finance system: mortgages guaranteed by Fannie Mae and Freddie Mac.
For years, policymakers have fretted about the global imbalances embodied in the U.S. trade deficit and associated surpluses in China, Japan and oil-exporting countries, the FT also reported. The fear was that if these were to unwind rapidly, with confidence evaporating in the U.S. economy and the dollar, the outcome would be grim. In 2006, the IMF said a disorderly reduction in the U.S. trade deficit would involve "a more rapid fall of the U.S. dollar, volatile conditions in financial markets, rising protectionist pressures, and a significant hit to global output". Dominique Strauss-Kahn, the IMF managing director, yesterday made it clear that some of those fears are materializing."For a long time the dollar was in a situation where its downward movement was predictable. We are now in a situation that is more stretched," he said. "It's a problem for economic growth. We clearly face a situation in which the risks to economic growth are more and more serious."The prospect of full-blown official foreign exchange intervention was played down yesterday by the head of the IMF as the euro's surge to another record high created a fresh headache for the ECB, the FT reported. "It doesn't appear that in this situation central banks need to intervene," said Dominique Strauss-Kahn, IMF managing director.
As jittery investors digested Washington's dramatic steps Sunday to broker a bailout of Bear Stearns Cos. and offer emergency credit to Wall Street firms, the possible outlines of a broader response to the U.S. financial crisis began taking shape, The Wall Street Journal reported today. The result is likely to be a heavier hand of government in the form of corporate bailouts, fiscal incentives and regulation. In the wake of the Bear Stearns deal, fears persisted that the credit-market woes might damage the broader U.S. economy. Overseas markets sold off sharply prior to the start of the U.S. trading session. The dollar also faltered badly, at one point hitting its lowest level against the yen since August 1995. In the financial sector, National City plummeted 43% on reports it was having a hard time finding a buyer. Lehman Brothers dropped 19%.
Far more than at any time before, the Federal Reserve is putting its vast resources and its reputation on the line to rescue Wall Street's biggest institutions from their far-reaching mistakes, The New York Times reported today. Over the next few months, the central bank will lend hundreds of billions of dollars to banks and investment firms that financed a mountain of mortgages now headed toward default. No one knows how many financial institutions will be looking for money, or how much they will seek. No one knows how much in hard-to-value securities the central bank, in return, will have to hold as collateral."
The Fed's decision this afternoon will not give us a clear answer to which way we are heading if the Fed does its job well in striking another balance in the moving equilibrium between economic implosion and currency devaluation. But it will help us to chart the progress as Bernanke navigates the current danger, ironically of the Fed's own creation. Is there a real end in sight? Or is the Fed merely prolonging the problem through financial turmoil and manipulation as the US Dollar empire declines?
"Beauty is but a flower,Greece fell. Persia fell. Egypt fell. Rome fell. And life went on. We can only conduct ourselves with honor and grace, as best we can, as this page of history slowly and raggedly turns.
That wrinkles will devour.
Brightness falls from the air.
Queens have died, young and fair;
Dust hath closed Helen's eye.
We are sick, and must die.
Lord have mercy on us."
"The world will know that free men stood against tyranny, that few stood against many, and that before this battle is over, even a god-king can bleed."
