Sunday, September 09, 2007

Waiting for the Witch Doctor / Hussman

If you are a bull and still believe that rate cuts from the Fed will save this market you should stop reading.... If you want to read what Hussman has to say what is the primary cause for inflation watch this chart or click on the headline to read the entire piece.

Solltet Ihr bullish für die Märkte sein und daran glauben das die kommenden Zinssenkungen der Fed diesen Markt wirklich retten können solltet Ihr besser nicht weiter lesen.... Desweiteren hat Hussman eine erschreckend einfache Inflationsindikator ausfindig gemacht. Hier die Kurzform im Chart oder aber die längere Version wenn Ihr auf die Überschrift klickt.

Given Friday's substantially weak employment report, the universal and unrelenting topic on Wall Street is whether the Fed will ease monetary policy in its September meeting, and by how much. This is an amazing exercise in superstition. This is not to say that the Fed's actions will be unimportant. It's just that whatever the Fed does, the impact will be almost entirely psychological. I've written about superstition and the Fed before, but given the dominating focus on the Federal Reserve here, it's important to refresh those comments.

> Thanks to Wall Street Follies

There's no question that interest rates – market determined interest rates – have a substantial role in economic activity, particularly on the durable goods and housing sectors of the economy. But if you look carefully at what the Fed does, and the instruments it uses, economists and even central bankers (both at the Fed and internationally) are at a loss to describe the “monetary transmission mechanism” in any detail – that is, why the tools of monetary policy should actually exert an effect on the real economy.

The problem, as I've noted before, is that since the early 1990's when reserve requirements were removed for all bank deposits except checking accounts, there is no longer any relationship between the volume of bank reserves and the volume of lending in the U.S. banking system (see Why the Fed is Irrelevant for a more complete review of the data).

> If you want to read more on this topis i highly recommend What (Really) Happened in 1995? / Aaron Krowne

> Wenn Ihr genaueres über die laxen Resrevevorschriften wissen möchsten kann ich Euch diesen Link What (Really) Happened in 1995? / Aaron Krowne

Simply put, you can draw a clear connection between Federal Reserve operations and the monetary base. You can draw a connection between the monetary base and the overnight Fed Funds rate. You can draw connections between market interest rates, bank lending, and economic activity. But what you can't do in any specific, meaningful way is to complete the diagram by drawing a cause-and-effect connection between the monetary base and the Fed Funds rate on one hand, and market interest rates and bank lending on the other. Yes, in crises, you can – briefly. If there's a bank run, the Fed has a real and essential role to play in supplying emergency liquidity. Outside of that, the monetary transmission mechanism is hypothetical at best.

It's strange that Wall Street makes such strong assumptions about the link between monetary policy and economic outcomes when there's no agreement among economists and central bankers about how changes in the quantity of the monetary base should exert an effect on the real economy. Again, there's clear agreement that market interest rates matter. There's also clear agreement that the Fed has direct control over the monetary base, and approximate control over the overnight Federal Funds rate. But that's where the agreement about fact ends and the debate about theory starts. .......

A small base of influence
Recall that the only thing that the Fed can do is to change the mix of government liabilities held by the public. When it “eases” monetary policy, it purchases Treasury securities, and recently, government backed mortgage securities, and replaces them with monetary base (currency and bank reserves).

As it happens, the vast majority of the base money created by the Fed is drawn off as currency in circulation – very little is actually retained as bank reserves. Indeed, of the $15.9 billion in monetary base the Federal Reserve has created over the past year, all of it has been drawn off as currency, leaving bank reserves about $2 billion lower than last year. That's not unusual. Total bank reserves have been gradually declining since the early 1990's. Since then, in contrast to what I used to teach my undergraduates about “money multipliers” and such, there no longer any link between the quantity of bank reserves and the volume of bank lending.

Moreover, it's unclear exactly how changes in the Federal Funds rate presumably cause changes in market interest rates – statistically, market rates lead and Fed Funds typically follow. We can of course argue that, well, the markets are anticipating the Fed. But why do we really need so badly to believe that a government entity that influences an overnight interest rate on a $41 billion pool of money (this is the entire amount of U.S bank reserves) is actually in tight control of a $13.8 trillion economy?

Think about it. The full range of variation in the U.S. monetary base (including both bank reserves and currency in circulation) typically amounts to only about $50 billion annually. Over the past year, foreign holdings of U.S. government debt have increased by $300 billion – more than six times the fluctuation in the monetary base, and over a hundred times the amount by which U.S. bank reserves have changed.

It might seem that Fed must have an effect because periods of easing are typically followed by subsequent economic recovery, and periods of tightening are typically followed by economic softness, albeit with a “long and variable lag.” But that's a lot like saying the sun comes up because the rooster crows. The Fed generally only raises the Fed Funds rate when the economy is near full capacity and continues until the economy softens. It lowers the Fed Funds rate when the economy is already weakening and continues until the economy recovers. The Fed is “effective” as surely as economic softness follows strength and strength follows softness.

Even if a round of Fed easing will eventually be followed by economic strength, we should not prefer it. By that sort of logic, a major spike in unemployment would be a great thing, because as we know, such spikes are also typically followed by economic recoveries, though with a long and variable lag.

Ultimately, what's really going on is that we in free market economies are very uncomfortable with the idea that there's nobody in control. As Voltaire said, “If there were no God, it would be necessary to create him.” And since we can be pretty sure that God's first priority isn't bailing out the mortgage market, we look to the Fed. When things are going smoothly, we understand that the economy is complex, and diffuse, and driven by millions of individual decisions. But when trouble strikes, we want to believe that there's somebody up at headquarters with their hands firmly on the controls of the entire operation.

Still, just as Pavlov's dog salivated when he rang the bell, investors have been conditioned to believe that the Fed matters. And so it does. But it's important to recognize that this effect is primarily psychological. Unfortunately, the belief that the Fed somehow has our back creates a “moral hazard” by encouraging speculative risk. One might recall that the Fed did not prevent the U.S. stock market from losing more than half its value several years ago, despite fourteen consecutive rate cuts.

What the Fed does next week will certainly have an effect on short-term market psychology. The Fed can also have an impact by maintaining liquidity in the banking system in response to short-term demands for withdrawals. But managing the day-to-day demand fluctuations in a $41 billion pool of funds will not cure the much deeper solvency issues in the trillion dollar mortgage and commercial paper markets. To believe otherwise is plain and dangerous superstition.
> Here the latest Fed view from Paul McCulley/ Pimco predicting / beggin for rate cuts

> Hier das letzte Update von Paul McCulley / Pimco die mehr oder weniger massive Zinssenkungen erwarten bzw. herbeisehnen

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Blogger jmf said...

Crisis in Asset Backed Commercial Paper
from Mish

2:38 AM  

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