"Artificial Easing" by the Fed

For the last few days, our banking system (and therefore our economy) has been suffering a liquidity crisis.  A liquidity freeze means that the banks don't have the funds to finance even the best-quality short-term loans.  In short, that's really bad news.  Larry Kudlow summarized it accurately on his show yesterday:

Without liquidity, this economy cannot grow.

No wonder the Fed has been stepping in with massive liquidity injections in the last few days.  In effect, the Fed has reduced its so-called target rate without actually saying they've reduced it.  Take a look at this startling chart of daily interest rate data; we may never again see another one shaped quite like this.

Click to enlarge:

The white line (fed funds rate) is determined by the banks who borrow and lend reserves among themselves overnight; the Fed usually tries to keep it close to the Fed's target rate (5.25% today) by injecting or withdrawing reserves (base money).  Usually.  But the last two days weren't usual days; the vertical free fall in the white line was caused by the Fed's massive liquidity injection.  The vertically-dropping red line, by the way, is a massive flight to the safety of short term US Treasury securities in the last two days.  My jaw dropped when I charted those two lines. 

Why did the white line drop almost vertically?  Because of the Fed's liquidity injection, the banks didn't need to borrow much at all from each other to comply with the Fed's reserve requirements.  The Fed vice chairman reportedly called it "artificial easing" (or "indirect" easing; I couldn't find the exact quote before press time).  To me, that sounds like a fancy way of simply saying "easing."  [That process, incidentally, is what most people mean when they say the Fed "prints money."  Contrary to the stigma some have attached to "printing money," it is absolutely necessary to sustain real growth, and is occasionally necessary to prevent a collapse.) 

Regarding the Fed's interest rate target versus its open market operations, something's gotta give: to get the white line closer to the Fed's advertised target rate, the Fed either needs to reduce its target rate, or remove liquidity from the banking system.  The latter would be one of the dumbest moves by the Fed since 1929; I therefore predict that the Fed will reduce its target rate soon, possibly before its next scheduled meeting in mid-September; a decrease from 5.25% to 4.75% wouldn't surprise me a bit.  [Although I hardly ever predict interest rates, there aren't many other things besides "easing" that can happen in this highly unusual case.]

[UPDATE, 7:20 am CDT, 8/17/07:  The Fed did indeed cut the discount rate by a half point.  That was quick.  See http://tinyurl.com/3738na ]

Political ramifications
It always comes back to politics one way or another, doesn't it?  In this case, it goes like this: (a) too many bad mortgage loans—by stupid lenders who deserve to go broke—will probably cause house prices to fall; (b) unless sufficient liquidity can mitigate that problem, lower house prices would reverberate through the economy, eventually dampening consumer spending; (c) a big-enough slowdown in consumer spending would cause a recession; (d) a recession during election time almost always causes the party that gets blamed to lose the election, badly. 

As a result, look for the president to meet with the Fed chairman and the Treasury secretary soon, for a photo op and a chance to emphasize the government's intent to fix the liquidity problem, with vigor.  Whatever.  I hope their liquidity remedy works, because otherwise we can kiss the current economic boom goodbye, and say hello to a nine-month-or-longer recession starting in a few months. 

If that sounds a bit pessimistic, it is.  Maybe I'll be pleasantly surprised, though.

==========
End note:
Anyone interested in getting to know the members of the Fed Board of Governors a little better can start here, at the Fed's website:
http://www.federalreserve.gov/bios/

Comments

[Bob]

Steve,

I read Kudlows' entire piece on this. His usual optimism was not evident. So, that's a concern.

Bob Novak, however, writes that, if the Fed were to lower the funds target, it would be a defacto bailout of the hedge funds and other financial entities that created this mess. That makes sense to me as well.

In terns of a meeting with Bush and Bernanke, I read Kudlows' reference to Reagan and Volcker, but don't have a lot of confidence that will happen.

[Bob]

News is that they cut the discount rate by 50 bp to 5.75. The fed funds rate was left unchanged.

[Steve]

Bob:
I think Novak is wrong if he thinks it's a hedge fund bailout; he might be confusing a liquidity crisis with a credit crisis. Injecting enough money to unfreeze the banking system so that it regains the ability to make good loans to untroubled companies is different from giving an undeserved reprieve to those who made stupid loans (or stupid purchases of mortgage-backed paper) and therefore deserve to go broke.

The former is absolutely what needs to be done, no question about it, and that's what the Fed is doing. As for the latter: not only does it not bother me in the least that stupidity is at last getting punished, I am unabashedly delighted to see it happen.

[Steve]

Bob:
You're right, thanks for the clarification; I was half-asleep when I heard the announcement this morning. The discount rate is the one that was lowered by a half point; that signals a probable decrease in the target fed funds rate, although it does not guarantee it. However, it definitely does signal a shift in Fed bias, towards easing, which should have significant immediate effects.

[salvatorem]

Three bits of bad macro news over the last few days:
1) Initial claims ticked up.
2) Housing starts were way down.
3) Philly Fed business indicator was flat.

Thats all the Fed needed to cut rates "to save the economy" and not have to worry about being accused of bailing out the hedge funds.

[Kurt Brouwer]

Steve. Nice post on the stealth easing of the target rate. I posted on it and linked to your post.

The housing starts statistic is significant because it hit a 10-year low. See here:
http://fundmasteryblog.wordpress.com/2007/08/16/new-housing-starts-10-year-low/

[woodchuck64]

I don't see how liquidity will help out housing now that the appetite for risky mortgage loans isn't there anymore. Keep in mind that the subprime debacle clearly started because risk was believed to be minimal or non-existent. Once the rumored death of risk is shown to be highly exaggerated, institutions can't unlearn that inconvenient fact and go back to issuing no-doc loans to reinflate the housing market. Mortgage rates and lending requirements will stay high until risk is slowly forgotten over the next few years.

Housing prices are heading down for a long time.

[ilsm]

No liquidity crisis.

The banks have enough good paper to sell to raise cash.

They decided to sit on good and get frustrated on the garbage paper they hold.

The fed bought paper amounting to what we see in public toilets last night.

Great!!

No bail out, soon the repo's come due, or someone gets bailed out again. Again. Again...

The underlying instruments are bad, the 20 prime players have worthless paper and want to be bailed out.

The Hedge Funds well.....

I can sell toilet paper for billions but I am not well connected.

[ilsm]

Here is what the fed has been repo'ing:

"The asset-backed commercial paper (ABCP) market, which started modestly as a way for banks to move assets off their balance sheet, using special purpose vehicles known as conduits, is today among the most innovative and complex financial sectors, often supporting entirely synthetic transactions.But its very success is arousing concern among some close observers. The market's role in shifting risk, often to exploit anomalies in the regulatory treatment of the banks' capital, looks distinctly uncertain when the rules change in three years time under current proposals."

[muirgeo]

Hmm, I'm confused. I've been reading this blog for a fair time. And I was under the impression that an economy based on deficit spending was nothing to worry about. Was this blog overly optomistic or just not skeptical enough?

[Steve]

muirgeo:
If you're confused, then you apparently read only the fiscal policy portion of this blog, and missed all the monetary articles about the need for sound money.

[Kerry Lohr-Williams]

Steve:

What are your signposts pointing to whether it's working or not?

My first post but longer term fan! You argue quantitatively and with charts – imagine!!

[muirgeo]

Steve,

I'm certainly an amateur with regards to economic and monetary policy. Milton Friedmans book is next on my list.

It just seems contradictory to the claim that markets are self correcting when in fact they appear to be highly dependent on the fed doing the right thing for their success.

[Steve]

muirgeo:
Markets are best at self-correcting when they don't have to worry about the value of money changing, in addition to everything else they have to evaluate. Unanticipated inflation or deflation just adds more uncertainty.

For the most concise description of monetary economics and how the Fed operates, I strongly recommend doing what I did a while back: I went through this paper sentence by sentence until I got it.
http://tinyurl.com/ypkl8h

[Steve]

rg:
The Fed isn't assuming any loss; they buy only the highest quality bonds/bills/notes, most if not all government-backed such as T-bills, from the private sector. Picture new dollars created by the Fed moving into the private sector, to pay for the bonds the Fed is buying from the private sector. Many of those transactions were "repurchase" agreements, which means the private sector agrees to buy those bonds back at the end of a specified time period. The net effect is a temporary injection of liquidity (cash) by the Fed into the private sector.

mark:
The Fed saw the liquidity crunch, and injected so much extra reserves that the fed funds rate fell, and has stayed, below the Fed's advertised target of 5.25%. When the banks have insufficient reserves to make even the safest short term working capital loans to the safest companies, the danger is a banking system freeze-up. That's not a credit-quality crunch, it's a liquidity crunch.

Half of the pundits say the Fed will adjust the reserves to get it back up to 5.25%; the other half of them say the Fed has almost no choice but to lower the target to 5.00 or 4.75%. Interestingly, all of the pundits I'm talking about are ex Fed folks. There's a diverse array of opinions even in that crowd.

When I look at the plunging rate on the shortest-term treasuries (1-month and 13-wk T-bills), and the huge gap that creates with the fed funds target, I have to lean with those who predict the Fed will have to lower the advertised target rate (to square with their defacto lowering of the actual rate, as shown at this page from the NYFRB: http://tinyurl.com/54c7j ).

Caution: I am a terrible predictor of interest rates, and should probably stop trying. Everybody should go read Brian Wesbury's latest take for a balancing viewpoint; it's in this document: http://tinyurl.com/258vy7

Again, however, I will be keeping a close eye, daily, on the fed funds rate at this page: http://tinyurl.com/54c7j , and also on the 1-month and 13-week T-bill rates. Psychology (i.e., fear) has been ruling the action in the last few days, and those interest rates are an indicator. The lower the 13-wk T-bill rate, the higher the demand for safety. The bigger the gap between that and the target fed funds rate, the more the pressure for the fed to lower the target.

Brad:
We must have read Brian's paper simultaneously.