Minyan Mailbag: A Powerless Fed?
The Fed has essentially lost what little power it had to control the supply of money (credit).
I think there is some wrong-headed thinking going on about the sub-prime fallout and the availability of lower debt costs going forward. The sub-prime fallout affects a subset of a subset of a subset in the market . However, the effect going forward will be to lower the cost of debt as 10-year treasuries fall substantially. Christopher Sullivan, CIO of the United Nations Federal Credit Union noted "Treasuries will be the direct beneficiaries."
If, as noted in Minyanville Friday, the Fed's key philosophy is to maintain consumption at all costs, it is a no brainer that the Fed will cut rates down the road if sub-prime and Alt-A issues expand. 10-year T-notes are already going down, but if the Fed cuts in 3-4 months, further decreases are in store.
Remember what happened in the late 90's? The market exploded after that for three years. If the sub-prime issue continues to grow, look for rates to go down. And that low rate will fuel more spending mischief.
It should be clear over the last seven years (since the 2000 recession) that what the Fed does is irrelevant to the cost of credit...but hugely relevant to the buck.
This perspective is status quo: If problems occur, the Fed will lower rates. Always it is in people's minds that the Fed has more power than it really has...the power to cure all ills. This smacks at the heart of logic. The Fed can lower rates only if they are willing to allow the money supply to explode. Already M3 is growing at unprecedented rates.
But because the US is beholden to foreign lenders now, even this assumption is no longer valid. The Fed has essentially lost what little power it had to control the supply of money (credit).
World speculation is already at a fever pitch. With China reluctantly raising rates, along with the rest of global central banks (although not very aggressively), and with real interest rates clearly still negative, the Fed would surely be on its own in lowering Fed funds. They can do it, but the negative consequences we have pointed out many times.
The argument that subprime is a sliver of a sliver of the market is a straw-man argument. Financial engineering has taken care of that. By slicing and dicing mortgages, financial engineers have made the market much more ubiquitous. The subprime "slice" now acts as part of the whole, bringing down the collateral value of all the leverage built into the system. It has greatly increased correlation and thus leads to a much riskier mortgage market as a whole. As the collateral value declines, new lending activity falters and the overall costs go up commensurately, even for "good" borrowers. This creates a higher probability of a housing depression as all that leverage unwinds, which will create greater deflationary pressures in the economy.
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