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The Fed


Kevin Depew and I were musing about the long standing bet that we have on the Fed: we bet over the summer that the Fed would lower rates, he said by Jan 05, I said by June 05. I already won the case of Pabst Blue Ribbon but I hold firm to my prediction that the Fed will lower rates by June 05. Why? Take a look at a chart of the Fed Fund target rate vs the 30 year bond yield. It is axiomatic (and entirely un-debatable) that the Fed follows the bond market when setting interest rate policy. And usually they do this within a short period of time: when rates turn down in earnest, the Fed is not usually far behind.

But when they do overstay their welcome and continue to raise rates while longer term rates are manifestly decreasing, well, that particular policy mistake could have ramifications. That old unintended consequence genie.

In any case, in the last 25 years, the Fed has been pretty good about following the bond market: lowering rates 1-3 months after the bond market lowered them, raising rates 1-3 months after the bond market raised them. But there have been 2 times in that time span when the Fed has lagged the bond market more considerably. Overstayed their welcome perhaps or just plain misread the macroeconomic tea leaves.

January 2000 to January 2001. And May 2004 to now. Both times the Fed was raising rates while the 30 year yield declined materially. In 2000, the 30 yr yield declined 124 bps while the Fed raised the Fed funds target rate 100 bps and then started their easing campaign. And so far this time around the 30 yr yield has declined 111 bps while the Fed Funds target rate has increased 150 bps.

There are many many reasons why the economy slowed in 2000 and assets in general started to deflate. But coincident to that was a mindset at the Fed that they could manage the economy, that such petty, pedestrian things as the business cycle were for lesser autocrats. That mindset, as evidenced by the Fed insisting they are right and the bond market is wrong - by ignoring the collective reasoning of millions of bond investors - is telling.

They are at it again. And for the economy, the Fed's hubris couldn't come at a worse time.
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