There is an excellent opinion article in the Wall Street Journal today by Arthur Laffer (see WSJ article). In the article, Laffer discusses the increase in the monetary base, and how in the past 95% of the monetary base was composed of currency-in-circulation. Even with the recent unprecedented increase, cash-in-circulation has risen only 10%, now making up less than 50% of the monetary base, whereas bank reserves have increased nearly 20-fold. Granted, an increase in bank reserves was needed as a result of the liquidity issues of 2008 in order to make it possible for banks to begin lending again, but the balance has shifted too far. Laffer points out that banks will no doubt continue to make loans until they are once again reserved constrained. Currently, as banks make more loans and put more money into the system, the growth rate of M1 (currency in circulation, demand deposits, and travelers checks - see wikipedia article) is now around 15%. This of course will result in higher inflation and higher interest rates. As mentioned by Laffer,

"In shorter time frames, the expansion of money can also result in higher stock prices, a weaker currency, and increases in commodity prices such as oil and gold."

Does this market situation seem familiar? Unless the Fed acts to reduce the monetary base, which appears unlikely anytime soon given that there is no easy approach or outcome (see the Laffer article), it appears likely that the Fed will continue to lose control over rates (see previous post), and the markets will continue to tip towards inflation (see additional previous post). Plan accordingly.

The flood of borrowing in the U.S. is eventually going to force us to pay the piper, with some arguing that the bill may come sooner than later. Others have argued for continued deflation over the next 12-18 months (see previous post). Fortunately, or unfortunately, depending on your perspective, the move from deflation to inflation might not be as sharp as expected (see Bloomberg article). As it turns out, rising home vacancies across the U.S. are depressing rents, the largest item in the consumer price index released by the labor department. Home and apartment rents, as well as owners' equivalent rent, make up 30 percent of the CPI. As of the third quarter of 2008, the number of empty homes stood at 19 million, signaling that deflation may be here to stay for a while - or at least worries of inflation can wait until 2010, at the earliest. While not a perfect scenario, an environment with lower inflation will allow the Fed some extra time before it needs to start raising rates, thereby giving lower rates more time to do their magic without the threat of stagflation.

Money markets are signaling that recent credit problem may be long from over, with possibly the worst yet to come (see Bloomberg article). As with the end of 2007, interest-rate derivative are showing hesitation from the markets over fear that credit losses will continue to increase. The premium banks charge for lending short-term cash is near 77 basis points over what traders predict the Federal Reserve's daily effected federal fund rate will average over the next three months - approaching the record levels set last year and near recent high levels (see recent posts here and here). The spread is up from 24 bps earlier in the year. The spread effectively measures the difference between the three-month Libor and the overnight indexed swap rate and is often used to tell whether or not the markets have returned to normal. Often a narrowing of 25 bps or less in the Libor-OIS spread is considered positive. Unfortunately, the forward markets do not indicate this happening for nearly two years, around June 2010. Of course, the reliability of Libor has also been in question recently (see previous posts here and here). Nonetheless, the size of the spread still shows a level of fear in the credit markets that may take a while to correct itself as investors wait for the next shoe to drop in the financial stocks.

Watching the post-Fed announcement finance shows (both before and after the market close), along with a read of the print media on the Fed's move, brings up a number of observations regarding the recent decision. The most interesting observation is how the market participants and pundits really, and I mean really, wanted a halt in interest rates, now or in the future, along with at least a neutral bias. Of course, the market did not get what it wanted. Or did it?

As the statement was released, every word was parsed to find its hidden meaning, or at least to see what was different from the last statement (more about this is a moment). What may be even more interesting is how all the hand wringing may have just been wasted energy, as the contents of the Fed report almost seemed to not matter. The majority of the pundits immediately talked about how the Fed has signaled a pause, some before they even read a word themselves. Even headlines from the major print media and other publications are using this and similar language - the Fed is pausing.

Below is the exact statement as released by the Fed:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 2 percent.

Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further. Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters.

Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Gary H. Stern; and Kevin M. Warsh. Voting against were Richard W. Fisher and Charles I. Plosser, who preferred no change in the target for the federal funds rate at this meeting.

In a related action, the Board of Governors unanimously approved a 25-basis-point decrease in the discount rate to 2-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Cleveland, Atlanta, and San Francisco.

If you are having trouble figuring out what is different from the last meeting, have no fear - you are not alone. To make things easier, the WSJ has done all the heavy lifting for you, creating a parsing graphic - essentially taking the parsing of the statement to comical proportions. Even worse is how the pundits read into the statement what they want. My hope is that unlike the rest of us (myself included), the Fed spends more time worrying about the implications of their moves, and less about how the statement will be interpreted. Given the general nature of the statement, I suspect that this is not the case.

So let me join in the fun, and confusion.

Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further. Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters.

Interpretation: Therefore, we plan to pause. Well, maybe not. In fact, you could argue for just the opposite.

Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully.

Interpretation: Inflation is a mixed bag. Core is better, and the committee expects inflation to moderate in coming quarters. Nonetheless, energy and other commodity prices have increased, and there is still uncertainty. So what is the read? Since inflation is not as much of a problem (core), and commodity prices are moving just as they were during recent cutting, we can keep on lowering rates. Therefore, do we plan to pause? Well, again, maybe not. Like before, we could argue that they will stay the course, continuing to cut.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

Interpretation: The key for the pundits is the first line. Easing to date is working, has helped to moderate growth, and should continue to do so. Gone from the previous statement is the phrase "downside risk to growth remains." Different to be sure, but is "help to promote moderate growth over time" a big enough change to infer a pause? Some mention that the second line also supports the pause, but isn't this line simply the Fed's mandate? Others supporting the impact of the second line mention how "act as needed" has now replaced "act in a timely manner." Seems a stretch to me. So now, while not timely, the Fed will monitor developments and act as needed, either to increase growth or decrease inflation. Again, isn't this just their mandate?

In the end, the market is hanging on the "substantial easing" paragraph, assuming that a pause is in the cards. This may very well be the case, but I am not sure this is what the Fed is signaling, or intended to signal. Furthermore, I am not even sure this is what the market is now signaling. A Fed pause would imply a stronger dollar, lower commodity prices, lower prices for the related agriculture plays (like the fertilizer companies), and a general market rally. We really got little of this after the announcement on Wednesday. Maybe future market action will give more clarity.

[Update: Clarity - indeed. Nice rally Thursday. Since a number of resistance levels are being tested, the next few days/weeks will be interesting. The strong dollar, and its effects, played out today.]

Of course, maybe we are missing the point entirely. Debating the impact of the statement on the markets may be like debating a lagging indicator - it is what it is. Maybe it makes more sense to talk about how the market action today, and over the next two months, will impact what the Fed does at their next meeting. It is certainly starting to look more and more like the markets move and control the Fed, and not necessarily the other way around. With unclear statements, the Fed may be simply hedging its bets. The current market action may be just a clue for what will drive the next decision. Of course, when that decision is made, and the statement is released to the market, we will once again need to roll out the parsing machine and let the silliness continue.

While seeming to follow, instead of lead, the Fed is contributing to the problem and giving the market the power. Like a spoiled child, the market did not get what it wants, and as a result, is not going to play nice. Trying to convince us that the Fed is done easing, regardless of whether that is actually the case or not, is not going to change the behavior. What the market needs is closure.

The Federal Reserve cut the federal funds rate by 0.25% to 2%. The discount rate that banks charge each other was also lowered 0.25% to 2.25%. There were two dissenters who preferred no cut. The bias was basically unchanged, although the analysts are frantically digging into the report to find some change. Apparently the line about downside risk is gone, or at least the word "downside" is gone, but they still mention how pressures exist and economic activity remains weak, with the markets remaining under considerable stress. Amazing how we find one word that is different and then start speculating on whether the Fed is planning to pause or not. I would not be surprised to see the market analysts begin to spin this as a pause, with the Fed now being neutral.

Still early, but the dollar is relatively flat, commodities are relatively unchanged, and the market is confused. Kind of a letdown, at least for traders. Given that the Fed will not meet for another 8 weeks, they may feel they will essentially be pausing for a few months, at which point they may have more clarity. It may take a while to see the full impact on energy, commodities, and the industrials.

LIBOR has been spiking downward in the last few months as the sub-prime mess has unfolded (see WSJ article). Some feel this sharp downward move is signaling more trouble ahead in the financial markets. As it turns out, this downward spike may be signaling a different problem. Remember that LIBOR is the global interest rate that is calculated each morning from rate data supplied to the British Bankers' Association, the group that oversees the calculation of LIBOR. LIBOR has become the global interest rate of choice, and while being used to price many option and futures contracts, it is also increasingly being used to set rates for corporate debt and home mortgages, throughout the world. The problem is that the data being supplied may not be reliable. The system for setting the rate depends on member banks telling the truth about their borrowing rates. Given that some banks, especially those in trouble, are paying higher rates for the short-term loans they need to finance operations, they should be reporting these higher rates. It is speculated that some are not. Why not you say? Because these same banks do not want to signal to their investors that they are in trouble, such that they not only need additional cash, but they are being forced to pay higher rates, possibly due to decreasing credit quality.

What does it mean? Well, if true, borrowers are getting a good deal, but of course, the banks that are loaning to the borrowers are getting the shorter end of the stick. Estimates show that the actual rate should be as much as 0.3% higher. Should we care? Yes. As mentioned in the WSJ, an extra 0.3% on a $500,000 loan is about $100 a month more in interest. If adjustable rates move up to the "real" LIBOR rate, the impact on the US, including California, Nevada, and Florida, in particular, could be significant. Given that much of the current mortgage debt is also "hedged" using interest-rate swaps, various banks and agencies may find that anticipated delta moves and positions are not achieving the goal they are looking for - reducing their risk. To address the problems, banks are already looking for alternatives, with some considering the overnight Repo rate as a better gauge of short-term lending given that securities are put-up for collateral, making for a more reliable measure of rates.

To date, there is no hard evidence that this practice is occurring, or that it is nothing more than a reflection of the general decline in lending and data, but banks are concerned, and the BBA is looking into it. As reported at Bloomberg, the BBA is even going as far as to "... ban any member deliberately misquoting lending rates at daily money-market operations ...." A nice step, but possibly adding more fuel to the fire. What may be more damaging is perception. Having the LIBOR rate come into question may be just another message that the market does not need on its mind.