"To Ease or Not, That is the Question"

Sydney M. Williams

Thought of the Day

“To Ease or Not, That is the Question”

October 7, 2010

Investor Business Daily had two squibs yesterday on page 2, under the title, “Economy”. The first quoted Chicago Fed chief, Charles Evans, who argued that the Fed should be far more aggressive in spurring the economy and bringing down unemployment. The second was an observation by Nobel Prize-winning economist Joseph Stiglitz – a man who supported last year’s stimulus plan – who claimed that the Fed’s efforts to flood the economy with cash are doing little more than sowing “chaos” in global currency markets. Together, the comments reflect the disparate opinions, as to how to revive the economy, ricocheting around Washington, academia and trading desks.

Unemployment at 9.6% remains elevated and economic growth at 1.7% (the revised number for the second quarter) will do little to alleviate that situation. The Fed cannot lower the Funds rate below zero; so they are left with quantitative easing, or rather a second round of easing, known as QE II.

The Fed has already expanded its balance sheet from $800 billion before the crisis to $2 trillion today, in an effort to keep long term rates low. Partly in consequence, the rate on the Ten-Year has declined from 3.84% at year end to 2.37% today – a 38% decline in yield in just over nine months. Thirty-year fixed rate conventional mortgages are 4.25% today versus 5.11% a year ago. On the other hand, according to Index Credit Cards, rates on consumer credit cards have risen from 15.38% a year ago to a range of 16.74% to 16.85%, suggesting that aggressive easing by the Fed has not meant lower rates for low income consumers. An additional factor suggesting that the Fed may be “pushing on a string” is to look at a Bloomberg chart depicting the velocity of money. For the last eight years the quarterly turn in money has been between 1.85 and 1.92 times. In the last six months of 2008 when credit conditions froze, velocity declined sharply to under 1.7 times. It rose modestly beginning in the spring of 2009, but, since May, has now declined to the low levels of early 2009.

It could be that the Fed is convinced that by flattening the yield curve the “carry” trade may disappear. Should that happen, the thinking might be, banks would then be willing to assume some risk and lend money to corporate or individual borrowers, in place of buying Treasuries. That remains to be seen.

The Fed and the Administration are stuck between a rock and a hard place. They have effectively taken short interest rates to zero and, through purchases, have helped keep long rates down, but nothing much has happened. On the other hand, they are afraid of the consequences of doing nothing. Banks are reducing lending and shoring up damaged balance sheets. Businesses, citing uncertainty, are not expanding, or at least not hiring. Consumers are spending only on essentials – the effective result being a regressive tax. Unemployment remains elevated. Countries are competing as to who can cheapen their currency the quickest.

As an expert on the 1930s, Fed Chairman Ben Bernanke appears to particularly fear deflation, so is willing to run the risk of inflation. Inflation, though, can also be insidious, as we in this country learned in the late 1970s and the early 1980s and, as the Germans have never forgotten from the days of the Weimar Republic’s hyperinflation in 1921-1923. A good friend tells me that the only good thing to come out of those hyperinflationary days in Germany was the number of young, attractive fräuleins who entered the world’s oldest profession!

An article in the October 5th issue of the Boston Globe suggests a “little hair of the dog” is being offered as a remedy. Fifty thousand dollar interest-free, two to three year loans are being offered by HUD to borrowers in Massachusetts who “have suffered a significant drop in income and [are] at least three months behind on mortgage payments.” Crises are almost always orphans, but the truth is this one has many fathers: Wall Street, Politicians, mortgage brokers and mortgage banks, real estate agents, homebuilders and millions of people who took advantage of easy credit and dream-like expectations that the good times would continue to roll. But when this ball dropped it did not bounce and the sad fact is we are all experiencing hangovers for past excesses, which will likely persist for some time.

It may well be that the Federal Reserve will be able to dance through the rain drops, implementing another round of easing and then unwinding the positions before they begin to bite, though the odds against are long. Speaking in Toronto yesterday, former Fed Chairman Paul Volcker said: “The challenge now is we have intervened, it becomes more and more difficult, the monetary policy…the fiscal policy. We sure have to maintain some confidence in the Dollar or none of this would work.” Charles Schwab put it well in last weekend’s Wall Street Journal: “Our economy is ready to heal. It just lacks broad-based confidence among consumers and business people. It would be a giant boost to confidence if the Fed stood aside and returned to its traditional role as defender of monetary stability.” Mr. Schwab is right. Faith in the Dollar and a restoration of confidence are more critical than flooding the nation with money.